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Your client’s risky portfolio is fully invested in bonds which have a standard deviation of 13%....

Your client’s risky portfolio is fully invested in bonds which have a standard deviation of 13%. Is it possible that adding stocks, which have a standard deviation of 25%, could reduce the risk of the client’s overall risky portfolio? Explain your answer.

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Answer #1

No, it is not possible to reduce overall risk of the portfolio by adding stocks with a SD of 25% to a fully invested bond portfolio with a SD of 13% since overall risk consisits of:

1. Standard Deviation

2. Beta risk

We can see that SD of Stocks is already almost twice the SD of Bonds and since stock market is more volatile than Bond markets, we cannot expect a beta of stock market to be less than beta of Bond market.Hence, adding a stock portfolio to fully invested bond portfolio will most likely increase the overall risk.

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