You are currently only invested in the Natasha Fund (aside from risk-free securities). It has an expected return of 14% with a volatility of 20%. Currently, the risk-free rate of interest of 3.8%. Your broker suggests that you add Hannah Corporation to your portfolio. Hannah Corporation has an expected return of 20%, a volatility of 60%, and a correlation of 0 with the Natasha fund.

Question

You are currently only invested in the Natasha Fund (aside from risk-free securities). It has an expected return of 14% with a volatility of 20%. Currently, the risk-free rate of interest of 3.8%. Your broker suggests that you add Hannah Corporation to your portfolio. Hannah Corporation has an expected return of 20%, a volatility of 60%, and a correlation of 0 with the Natasha fund.
a. Is your broker right?
b. You follow your broker’s advice and make a substantial investment in Hannah stock so that, considering only your risky investments, 60% is in the Natasha Fund and 40% is in Hannah stock. When you tell your finance professor about your investment, he says that you made a mistake and should reduce your investment in Hannah. Is your finance professor right?
c. You decide to follow your finance professor’s advice and reduce your exposure to Hannah. Now Hannah represents 15% of your risky portfolio, with the rest in the Natasha Fund. Is this correct amout of Hannah stock to hold?

Bot · Answer

a. Your broker is right in the sense that adding Hannah Corporation to your portfolio will improve your diversification, given that it has a correlation of 0 with the Natasha fund. Diversification can help lower the overall volatility of your portfolio without sacrificing expected returns.

b. Your finance professor might have concerns about the degree of investment in Hannah because of its relatively high volatility (60%) compared to the Natasha Fund (20%). While diversification can be beneficial, a 40% allocation in a high-volatility stock like Hannah may increase overall portfolio risk. It would be essential to assess the portfolio's risk and return profile after the investment adjustment to determine if the new allocations align with your risk tolerance and investment goals.

c. The correct amount of Hannah stock to hold in your portfolio depends on your risk tolerance and investment objective. By reducing the exposure to Hannah to 15% of your risky portfolio, you are decreasing the overall portfolio risk due to its high volatility. Still, it would be best to evaluate the resulting portfolio risk and return characteristics to ensure it meets your requirements. You might also consider other investments or optimizing your portfolio further to reach a balance between return and risk that suits your preferences.