F I L E D iv e rs ific a tio n is c o n s id e re d im p o r t a n t in fin a n c e because it allo w s investors to red uce risk by investing in a v a r ie ty o f assets. It is e s p e c ia lly e ffe c tiv e w h e n th e c o rre la tio n b e tw e e n th e assets is lo w . C o n s id er th e a cc o m p a n yin g ta b le , w h ich show s a p o rtio n o f m o n th ly d a ta o n clo s in g sto c k prices o f fo u r c o m p a n ie s in 2 0 1 0 .

Th e e n tire d ata can be fo u n d on th e te x t w e b s ite , lab eled 2 0 1 0 S tock R eturns.

Month Microsoft Coca Cola Bank of America General Electric Jan 27.61 49.52 15.13 15.64 Feb 28.22 54.88 16.61 15.72 Dec 27.91 55.58 13.34 18.29 Source: fin a n ce .ya h o o .co m .

a. C o m p u te th e correlation coefficients b e tw e e n all pairs of stock prices.

b. Suppose an investor already has a stake in M icrosoft and w o u ld like to add an o th er asset to her portfolio. W hich o f th e rem a in in g th re e assets w ill g ive h e r th e m a x im u m b e n e fit o f diversification? (H in t: Find th e asset w ith the low est correlation w ith Microsoft.)

c. S up pose an in vestor does n o t o w n a n y o f th e a b o v e fo u r stocks. Pick tw o stocks so th a t she gets th e m axim um b e n e fit o f diversification. P-69