Question

Campbell's father holds just one stock, A Co., which he thinks is a very low risk security. Campbell agrees that the stock is relatively safe, but he wants to demonstrate to his father that he could still reduce his risk by diversifying. He obtained the return shown below on A and B Corp. Both have had less variability than most other stocks over the past 5 years.

Year	A	B	Portfolio: 50% A and 50% B
2015	0.40	0.40
2016	-0.10	0.15
2017	0.35	-0.05
2018	-0.05	-0.10
2019	0.15	0.35
Average return	0.15	0.15
Standard deviation	0.2264	0.2264

a. Measured by the standard deviation of returns, by how much would historical risk have been reduced if A and B were held in a portfolio consisting of 50% in A and the rest of the money in B? (Fill in the blank on table)

b. Why is the risk reduced?

Answer 1

(b) Risk has been reduced because of diversification by investing in portfolio of two stocks .

When we invest in a portfolio of stocks which are not perfectly positively correlated then that combination always reduces or diversifies risk.