Assume that your uncle holds just one stock, East Coast Bank (ECB), which he thinks has very little risk. You agree that the stock is relatively safe, but you want to demonstrate that his risk would be even lower if he were more diversified. You obtain the following returns data for West Coast Bank (WCB). Both banks have had less variability than most other stocks over the past 5 years.
Year ECB WCB
2004 40.00% 40.00%
2005 -10.00% 15.00%
2006 35.00% -5.00%
2007 -5.00% -10.00%
2008 15.00% 35.00%
Average return= 15% 15.00%
Standard deviation=22.64% 22.64%
a. What is the expected return and risk of each stock?
b. Measured by the standard deviation of returns, by how much would your uncle's risk have been reduced if he had held a portfolio consisting of 60% in ECB and the remainder in WCB? In other words, what is the difference between portfolio's standard deviation and weighted average of components' standard deviations?