Question

Your current portfolio's returns over the past three years looked like this:

  

	Yr. 1	yr2	yr3	E(CF)	sigma(6)
your portfolio CF	100	100	100	100	0

The past three years are representative of a good year, an average year and a bad year for you.

you are considering adding one of these two equally priced assets to your portfolio

	yr1	yr2	yr3	E( CF)	Sigma(6)
New asset 1	2	6	10	6	4
New asset 2	10	6	2	6	4

Would have preference for which asset to add to your portfolio? Why or why not?

Answer 1

Our portfolio is similar to a risky free investment with zero risk ( Standard deviation is zero)

Among the new assets, the return and the standard deviation are same. The only difference arises that asset 1 behaves opposite to the total market because it has higher return in a bad year. Hence there may be diversification benefits from adding asset 1. However since our original portfolio has zero risk, adding either of the two assets will not make any difference in the long run.