7. Portfolio expected return and risk

A collection of financial assets and securities is referred to as a portfolio. Most individuals and institutions invest in a portfolio, making portfolio risk analysis an integral part of finance. Just like standalone assets and securities, portfolios are also exposed to risk. Portfolio risk refers to the possibility that an investment portfolio will not generate the expected rate of return.

Analyzing portfolio risk and return involves the understanding of expected returns from a portfolio.

Consider the following case:

Hubert is an amateur investor who holds a small portfolio consisting of only four stocks. The stock holdings in his portfolio are shown in the following table:

Stock	Percentage of Portfolio	Expected Return	Standard Deviation
Artemis Inc.	20%	8.00%	28.00%
Babish & Co.	30%	14.00%	32.00%
Cornell Industries	35%	13.00%	35.00%
Danforth Motors	15%	3.00%	37.00%

The expected return on Huberts stock portfolio is (16.2%, 8.1%, 10.8%, OR 14.58%).

Suppose each stock in the preceding portfolio has a correlation coefficient of 0.4 ( = 0.4) with each of the other stocks. The markets average standard deviation is around 20%, and the weighted average of the risk of the individual securities in the partially diversified portfolio of four stocks is 33%.

If 40 additional, randomly selected stocks with a correlation coefficient of 0.3 with the other stocks in the portfolio were added to the portfolio, what effect would this have on the portfolios standard deviation (pp)?

A. It would stay constant at 33%.

B. It would gradually settle at about 35%.

C. It would decrease gradually, settling at about 0%.

D. It would gradually settle at about 20%.