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Diversification is considered important in finance because it allows investors to reduce risk by investing in a variety of assets. It is especially effective when
Diversification is considered important in finance because it allows investors to reduce risk by investing in a variety of assets. It is especially effective when the correlation between the assets is low. Consider the accompanying table, which shows a portion of monthly data on closing stock prices of four companies in 2010. The entire data can be found on the text website, labeled 2010 Stock Returns.
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 |
Mar | 28.83 | 57.84 | 17.81 | 17.81 |
Apr | 30.06 | 54.31 | 17.79 | 18.46 |
May | 25.51 | 49.29 | 15.7 | 16 |
Jun | 22.75 | 47.47 | 14.35 | 14.2 |
Jul | 25.52 | 51.11 | 14.02 | 15.88 |
Aug | 23.33 | 49.5 | 12.44 | 14.26 |
Sep | 24.34 | 52.69 | 13.09 | 16.12 |
Oct | 26.51 | 53.08 | 11.44 | 15.89 |
Nov | 25.26 | 58.5 | 10.94 | 15.71 |
Dec | 27.91 | 55.58 | 13.34 | 18.29 |
- Compute the correlation coefficients between all pairs of stock prices.
- Suppose an investor already has a stake in Microsoft and would like to add another asset to her portfolio. Which of the remaining three assets will give her the maximum benefit of diversification? (Hint: Find the asset with the lowest correlation with Microsoft.)
- Suppose an investor does not owe any of the above four stocks. Pick two stocks so that she gets the maximum benefit of diversification.
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