During periods of high stock market volatility, the standard deviation of return

Question

During periods of high stock market volatility, the standard deviation of returns on the stock market increases. If the expected return on the stock market does notchange, a risk averse investor who wants to reduce the risk of his portfolio will

A.

decrease the proportion of his portfolio that is invested in the risk-free asset and earn a lower expected return on his portfolio.

B.

increase the proportion of his portfolio that is invested in the risk-free asset and earn a lower expected return on his portfolio.

C.

increase the proportion of his portfolio that is invested in the risk-free asset and earn a higher expected return on his portfolio.

D.

decrease the proportion of his portfolio that is invested in the risk-free asset and earn a higher expected return on his portfolio.

Explanation / Answer

In the investment market, return from stock is compared with risk. Risk is the scatteress of return. It is measured by standard deviation. With the increase in volatility of the market price, scatterness will increase. So risk will rise. Most investors are risk avert. So in volatile situation they will try to reduce risk. It is possible by diversification of portfolio.It can be diversified by investing in risk free asset. It is basically government bond. It has no liquidity problem since government controls supply of money. If required, it can print notes and circulate to solve this problem.

Thus a risk averse investor will increase proportion of portfolio in risk free asset. It will reduce expected return along with miinimization of risk.

Thus option B is correct.

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