Question

Consider the characteristics of the following three stocks: Expected Return Standard Deviation Thumb Devices 16 %...

Consider the characteristics of the following three stocks:

Expected Return Standard Deviation
Thumb Devices 16 % 29 %
Air Comfort 14 25
Sport Garb 14 22

The correlation between Thumb Devices and Air Comfort is −0.17. The correlation between Thumb Devices and Sport Garb is −0.22. The correlation between Air Comfort and Sport Garb is 0.83.

Select only two stocks for your portfolio based on low correlation and low risk.

  • Sport Garb and Thumb Devices

  • Air Comfort and Sport Garb

  • Air Comfort and Thumb Devices

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Answer #1

The two stock choosen should be those which will have lowest correlation so that the portfolio risk (SD) is minimised

Since, correlation between Thumb Devices and Sport Garb is −0.22, these should be choosen.

(Detailed Analysis, if required is shown below)

The weight of these two stock in the portfolio shall be decided by using the following formula

Wa = SDb / (SDa+SDb) and weight of Wb = 1 - Wa.

Portfolio Return=Wa*Ra+Wb*Rb

Portfolio SD =

where Wa = Weight of stock a ; Wb = Weight of Stock B; SDa = Standard deviation of stock A; SDb = Standard deviation of stock B; r = Correlation Coefficient between a & b

Calculations are shown below:

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