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 the field of finance. Just like stand-alone assets and securities, portfolios are also exposed to risk. Portfolio risk refers to the possibility that an investment portfolio will not generate the investors expected rate of return.

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

Consider the following case:

Andre 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%

6.00%

37.00%

Babish & Co.

30%

14.00%

41.00%

Cornell Industries

35%

12.00%

44.00%

Danforth Motors

15%

5.00%

46.00%

What is the expected return on Andres stock portfolio?

13.97%

7.76%

15.52%

10.35%

Suppose each stock in Andres portfolio has a correlation coefficient of 0.40 ( = 0.40) with each of the other stocks. The markets average standard deviation is approximately 20%, and the weighted average of the risk of the individual securities in the partially diversified four-stock portfolio is 42%.

If 40 additional, randomly selected stocks with a correlation coefficient of 0.30 with the other stocks in the portfolio were added to the portfolio, what effect would this have on the portfolios standard deviation (pp)?

It would gradually settle at about 35%.

It would gradually settle at approximately 50%.

It would stay constant at 42%.

It would gradually settle at approximately 20%.