Stock X and Stock Z both have an expected return of 12%. The standard deviation of the expected return is 10% for Stock X and 14% for Stock Z. Assume that the correlation between these two stocks is +0.3.
A. If you MUST hold one of these two stocks in isolation, which one would you select, and why?
B. What is the expected return and the standard deviation of a portfolio that includes 50% Stock X and 50% Stock Z?
C. If you must hold a two-stock portfolio consisting only of Stock X and Stock Z, what is the optimal percentage (between 0% and 100%) of the portfolio to put in Stock X? Stock Z?
D. Can diversification produce benefits if the correlation between two stocks is greater than zero? Explain why the answer is yes, using your answers to parts B and C.
E. Why is it likely (in reality) that the correlation between the returns offered by most stocks will be positive?