Question

When adding a randomly chosen new stock to an existing portfolio, the higher (or more positive) the degree of correlation between the new stock and stocks already in the portfolio, the less the additional stock will reduce the portfolio's risk.a) trueb) false

Answer 1

Answer:

true                                  

Explanation:

Assume, original stock was A. Now a new stock B is added.

Weight of Stock A in the portfolio=Wa

Weight of Stock B in the portfolio=Wb

Standard Deviation of Stock A=Sa

Standard Deviation of Stock B=Sb

Cova,b=Covariance between Aand B

Portfolio Variance=(Wa^2)*(Sa^2)+(Wb^2*Sb^2)+2*(Wa*Wb*Cova,b)

Correlation between A &B=(Cova,b/Sa*Sb)

Cova,b=Sa*Sb*(Correlation between A&B)

Hence,higher the correlation between A&B, higher will be the covariance (Cova,b).

Hence higher will be the Portfolio variance.

So, the reduction of risk will be lower.