Sonny owns $5,000 worth of High Risk Enterprises (HRE) stock. HRE has a standard deviation of 16 percent and a beta of 2.0. He wants to invest another $5,000 and create a $10,000 portfolio that is equally as risky as the overall market. Which one of the following will accomplish his goal?
A. invest the additional $5,000 in a security that is equally as risky as the market
B. sell HRE and invest the entire $10,000 in risk-free securities
C. sell HRE and invest $5,000 in risk-free securities and $5,000 in a stock that has a standard deviation of 4 percent
D. invest the additional $5,000 in a stock that has a standard deviation of 4 percent
E. invest the additional $5,000 in risk-free securities
To create a portfolio that is equally as risky as the overall market, Sonny needs to consider the beta of his current stock and the risk of the additional investment. Beta measures the sensitivity of a stock's returns to the returns of the overall market.
Since HRE has a beta of 2.0, Sonny's current stock is twice as risky as the overall market. To balance out the risk, Sonny needs to invest in a security with a lower beta or risk-free securities.
Let's evaluate each option:
A. Investing the additional $5,000 in a security that is equally as risky as the market: This option would not balance out the risk of Sonny's current HRE stock, as it does not reduce the overall portfolio's risk. Not the correct choice.
B. Selling HRE and investing the entire $10,000 in risk-free securities: This option would completely eliminate the risk of Sonny's portfolio. While it accomplishes the goal of creating a risk-free portfolio, it does not create a portfolio that is equally as risky as the overall market. Not the correct choice.
C. Selling HRE and investing $5,000 in risk-free securities and $5,000 in a stock that has a standard deviation of 4 percent: This option balances out the risk of Sonny's current HRE stock by investing in risk-free securities and a low-risk stock. It creates a $10,000 portfolio that is equally as risky as the overall market. Correct choice.
D. Investing the additional $5,000 in a stock that has a standard deviation of 4 percent: This option does not consider the risk of Sonny's current HRE stock. It may increase the overall risk of the portfolio and does not achieve the goal of creating a portfolio equally as risky as the market. Not the correct choice.
E. Investing the additional $5,000 in risk-free securities: This option does not balance out the risk of Sonny's current HRE stock, as it leaves the portfolio with a higher risk than the market. Not the correct choice.
So, the correct choice is C. Sell HRE and invest $5,000 in risk-free securities and $5,000 in a stock that has a standard deviation of 4 percent.
To answer this question, we need to find the option that will make Sonny's portfolio equally as risky as the overall market. Let's break down each option and evaluate its impact:
A. Invest the additional $5,000 in a security that is equally as risky as the market:
This option does not guarantee that the additional security will have the same level of risk as the market. Therefore, this option is not suitable.
B. Sell HRE and invest the entire $10,000 in risk-free securities:
Risk-free securities have zero volatility and do not add any risk to the portfolio. As a result, this option will not make the portfolio as risky as the market. Therefore, this option is not suitable.
C. Sell HRE and invest $5,000 in risk-free securities and $5,000 in a stock that has a standard deviation of 4%:
This option combines risk-free securities with a low-risk stock. Since risk-free securities have zero volatility, the overall risk of the portfolio will be determined by the stock with a standard deviation of 4%. This stock has lower volatility than the current HRE stock, so the portfolio will be less risky than the market. Therefore, this option is not suitable.
D. Invest the additional $5,000 in a stock that has a standard deviation of 4%:
This option adds a low-risk stock to the portfolio. The stock's standard deviation is 4%, which is lower than the 16% standard deviation of HRE. As a result, the overall portfolio will still be less risky than the market. Therefore, this option is not suitable.
E. Invest the additional $5,000 in risk-free securities:
Similar to option B, investing in risk-free securities does not add any risk to the portfolio. Thus, this option will not make the portfolio equally as risky as the market. Therefore, this option is not suitable.
Based on the evaluation, none of the given options will help Sonny achieve his goal of creating a $10,000 portfolio that is equally as risky as the overall market.