A highly risk-averse investor is considering adding one additional stock to a 4-stock portfolio. Two stocks are under consideration. Both have an expected return,, of 15%. However, the distribution of possible returns associated with Stock A has a standard deviation of 12%, while Stock B’s standard deviation is 8%. Both stocks are equally highly correlated with the market, with correlation equal to 0.75 for both stocks. Which stock should this risk-averse, will add to his/her portfolio? Explain with reasoning
Risk and return
Before understanding the concept of Risk and Return in Financial Management, understanding the two-concept Risk and return individually is necessary.
Capital Asset Pricing Model
Capital asset pricing model, also known as CAPM, shows the relationship between the expected return of the investment and the market at risk. This concept is basically used particularly in the case of stocks or shares. It is also used across finance for pricing assets that have higher risk identity and for evaluating the expected returns for the assets given the risk of those assets and also the cost of capital.
A highly risk-averse investor is considering adding one additional stock to a 4-stock portfolio. Two stocks are under consideration. Both have an expected return,, of 15%. However, the distribution of possible returns associated with Stock A has a standard deviation of 12%, while Stock B’s standard deviation is 8%. Both stocks are equally highly correlated with the market, with correlation equal to 0.75 for both stocks. Which stock should this risk-averse, will add to his/her portfolio? Explain with reasoning
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