Question

As we increase the number of stocks in a portfolio, the standard deviation of returns of the portfolio ________ if the stocks that comprise the portfolio are ________.

A.) increases; not perfectly positively correlated

B.) increases; perfectly correlated

C.) decreases; not perfectly positively correlated

D.) decreases; perfectly correlated

Answer 1

As we increase the number of stocks in a portfolio, the standard deviation of returns of the portfolio DECREASES if the stocks that comprise the portfolio are NOT PERFECTLY POSITIVELY CORRELATED.

answer is option C

If the stocks added in portfolio are perfectly correlated, means, they move in the same direction as the other stocks are moving, then the deviation will increase. So, on should add stock which are not perfectly positively correlated , ie of different business models or different industries, which will create a natural hedge.