Question

There is a very volatile security which pays you a positive return when the market performs poorly and a negative return when the market performs well. The expected return on this asset is 2%, which is equal to the risk-free rate. It would never be optimal to include this asset in a rational mean-variance investor’s portfolio.

Is this statement true or false? Explain

Answer 1

The statement is false

This asset is moving in the direction opposite to the market so this implies the asset is negatively correlated to the market. Adding negatively correlated stocks in a portfolio with all positively correlated stocks can help reduce risk in the portfolio. When building a diversified portfolio, investors try to add negatively correlated stocks and by doing so investors reduce the risk of catastrophic losses in the portfolio. Assume the portfolio consists of two stocks and they are negatively correlated. This implies that when one stock performs worse than usual, the other will likely do better than usual.