The article “Rethink Diversification to Raise Returns, Cut Risk” (San Luis Obispo Tribune, January 21, 2006) included the following paragraph: In their research, Mulvey and Reilly compared the results of two hypothetical portfolios and used actual data from 1994 to 2004 to see what returns they would achieve. The first portfolio invested in Treasury bonds, domestic stocks, international stocks, and cash. Its 10-year average annual return was 9.85% and its volatility— measured as the standard deviation of annual returns—was 9.26%. When Mulvey and Reilly shifted some assets in the portfolio to include funds that invest in real estate, commodities, and options, the 10-year return rose to 10.55% while the standard deviation fell to 7.97%. In short, the more diversified portfolio had a slightly better return and much less risk. Explain why the standard deviation is a reasonable measure of volatility and why it is reasonable to interpret a smaller standard deviation as meaning less risk.
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