Benefits of

diversification.

Sally Rogers has decided to invest her wealth equally across the following three assets:

States Probability Asset M Return Asset N Return Asset O Return Boom 27% 14% 23% 6% Normal 53% 12% 16% 12% Recession 20% 6% 3% 14%

. a.What are her expected returns and the risk from her investment in the three assets? How do they compare with investing in asset M alone?

Hint:

Find the standard deviations of asset M and of the portfolio equally invested in assets M, N, and O.

b.Could Sally reduce her total risk even more by using assets M and N only, assets M and O only, or assets N and O only? Use a 50/50 split between the asset pairs, and find the standard deviation of each asset pair.

Question content area bottom

Part 1

a.What is the expected return of investing equally in all three assets M, N, and O?