Question

Suppose you have three stocks A, B, C the three stocks have the same expected return and the same standard deviation. If you know that the correlation coefficient between each pair of stocks are as follows:

The correlation between A and B is +0.9

The correlation between A and C is 0.1

The correlation between B and C is -0.6

You want to form a portfolio consists of two securities Given the correlations above, a portfolio constructed of which pair of stocks will have the lowest standard deviation? What do you conclude?

Answer 1

The lowest standard deviation will be delivered by below:

·       The correlation between B and C is -0.6

Reason: The negatively correlated stocks i.e. correlation of -0.6, would throw a lowest standard deviation for the portfolio. Negatively correlated stocks move in opposite direction and that brings down the total risk or standard deviation of the portfolio in a general market conditions. Whereas, when stocks are positively correlated i.e. near to +1 or +0.9 or 0.1, which implies that two stocks move in same direction and hence that amplifies the overall risk and that results in high standard deviation of portfolio.