Question

If investors are risk averse and hold only one stock, we can conclude that the required rate of return on a stock whose standard deviation is 0.21 will be greater than the required return on a stock whose standard deviation is 0.10. However, if stocks are held in portfolios, it is possible that the required return could be higher on the stock with the lower standard deviation.
True / False.

Answer 1

Answer:

The answer is: True

Explanation:

Usually investors tend to be risk averse, reason why a higher risk must be matched by a higher return. If the returns of an investment are highly uncertain (their standard deviation is high), investors will require a higher rate of return. Uncertainty leads to higher risk, and higher risk leads to higher returns.

If we compare the rate of return of a stock A that has a standard deviation of 0.21, with the rate of return of a stock B that has a standard deviation of 0.10, we can conclude that:

Stock A has a higher investment risk than stock B, therefore investors will require a higher rate of return from stock A.

When stocks are part of a portfolio, diversification effects can lower their risk depending on what other stocks make up the portfolio.