Bert Smith, CFA, recommends three equity funds for his new client Walter Clay. Smith uses mean-variance analysis and optimization to derive allocation decisions. Clay admittedly knows little about investing beyond some knowledge of the benefits of diversification. Smith gathers data on the following three funds, along with his recommended allocation:

Fund

Expected Return

Standard Deviation

Allocation

Blue Sky

8%

18%

60%

Green Earth

12%

25%

30%

Red Space

14%

31%

10%

The correlation matrix:

Fund

Blue Sky

Green Earth

Red Space

Blue Sky

1.00

Green Earth

0.63

1.00

Red Space

0.39

0.41

1.00

Clay asks for a detailed explanation from Smith on efficiency and correlation as well as the possibility of adding a risk-free security to the suggested portfolio. Smith responds with two observations:

Observation 1:We could add a risk-free government bond fund and this would provide more efficient allocation choices.

Observation 2:Adding a risk-free government bond fund will have significant diversification benefits because the correlation between the government bond fund and the suggested portfolio is likely to be negative.

Finally, Smith informs Clay that another fund, Core Fund, might be a good addition to his portfolio because it has an expected return of 15% and a standard deviation of 28%.

With respect to observations 1 and 2, Smith ismost likelycorrect in stating:

Question 4 options:

neither observation.

both observations.

observation 1, only.