Portfolio Management: Risk Reduction

[nnavigator]

Given 3 assets all with the same likelihood of occurrence:
Asset Outcome 1 Outcome 2 Outcome 3 Expected Return
1 12 0 6 6
2 12 6 0 6
3 0 6 12 6
If the analyst constructs two-asset portfolios that are equally weighted, which pair of assets provides the least amount of risk reduction?
A) Asset 1 and Asset 2.

B) Asset 1 and Asset 3.

C) Asset 2 and Asset 3.

Answer: A is correct. An equally weighted portfolio of Asset 1 and Asset 2 has the highest level of volatility of the three pairs. All three pairs have the same expected return; however, the portfolio of Asset 1 and Asset 2 provides the least amount of risk reduction.

Could someone please explain how a portfolio with Asset 1 and Asset two would have the least amount of risk reduction?

Thank you!

 

[S2000magician]

Compute the correlations of returns for 50/50 portfolios.

 

[nnavigator]

Thank you! Do you know if the calculation for correlation for this particular type of question is required for students to do during the actual exam? It is a little lengthy …

 

[S2000magician]

My pleasure.
It’s not likely that you’ll do that during the real exam, but it’s good practice now.