Two stocks, stock A and B, are available in the stock market. The price of the stock A today is $50. The price of stock A next year will be $40 if the economy is in a recession, $55 if the economy is normal, and $60 if the economy is expanding. The probabilities of recession, normal times, and expansion are 0.1, 0.8, and 0.1, respectively. Stock A pays no dividends and has a correlation of 0.8 with the market portfolio. Stock B has an expected return of 9 percent, a standard deviation of 12 percent, a correlation with the market portfolio of 0.2 and a correlation with stock A of 0.6. The market portfolio has a standard deviation of 10 percent. Assume CAPM holds.

Required:

1. If you are a typical risk-averse investor with a well-diversified portfolio which stock would you prefer? Why?

2. What are the expected return and standard deviation of a portfolio consisting of 70 percent of stock A and 30 percent of stock B?

3. What are your considerations if you would like to include additional stocks in your investment portfolio? Explain briefly.