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Q2. Risk and Returns The following graph plots the historical volatility against historical average return for a set of portfolios (treasury bills, corporate bonds, world
Q2. Risk and Returns The following graph plots the historical volatility against historical average return for a set of portfolios (treasury bills, corporate bonds, world portfolios, mid-cap stocks, and small stocks) as well as for individual stocks in the S&P 500 index. 25% A = Stocks 1-50 = Stocks 51-400 - Stocks 401-500 Small Stocks 20% Mid-Cap Stocks 15% S&P 500 Historical Average Return 10% Corporate Bonds World Portfolio 5% Treasury Bills 096 0% 5% 10% 15% 20% 30% 35% 40% 45% 50% 25% Historical Volatility (standard deviation) The graph shows that the relation between historical volatility and historical average returns for portfolios (large red squares) is positive to the point that they lie almost perfectly on the dotted line. The graph also shows that there is not necessarily a positive relation between historical return and historical volatility for individual stocks (yellow triangles, blue diamonds and orange circles). a. Why do we observe different patterns for large portfolios compared to individual stocks? b. We can come up with two individual stocks on the graph where one has higher volatility but lower return. Does this violate the famous risk-return trade-off for individual stocks? Explain your answer. Please limit your answer to 3 sentences
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