Suppose you are considering investing an equal proportion of your wealth in two stocks. Stock C offers a 15% return while stock T offers a 25% return assuming a boom economy occurs for which there is a 30% chance of this occurring. If a normal state of the economy occurs, Stock C offers a 10% return while stock T offers a 20% return. There is a 50% chance of a normal economy. Finally, if a recession occurs, Stock C will offer a 2% return while stock T will offer only a 1% return. There is a 20% chance of a recessionary economy. 

1. Compute the expected return on your 2-asset portfolio.

 2. Compute the standard deviation of your 2-asset portfolio.

 3. Now assume that in addition to holding Stocks C and T as part of your portfolio, you decide to add Stock R to your portfolio. You will again invest an equal proportion of your wealth in each stock. Using the same probabilities of state outcomes and returns previously made for Stocks C and T, recompute the expected return and standard deviation on your portfolio under the assumption that Stock R will offer a -5% return in a booming economy, a 1% return in a normal economy, and a 15% return in a recessionary economy. 

4. What conclusion about the standard deviation can be made from your results above as you shift from a 2-asset portfolio to a 3-asset portfolio of uncorrelated assets?

 5. Will you be able to eliminate your level of risk by diversifying among more and more uncorrelated assets in your portfolio? Explain.

Answer rating: 100% (QA)

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