Question

2. When adding a risky asset to a portfolio of many risky assets, which property of the asset is more important, its standard deviation or its covariance with the other assets

Answer 1

Answer: Covariance with other Assets

Step-by-step explanation:

Covariance is used to describe the relationship between assets in terms of their movement together. If two assets are said to have a positive covariance, it means that their returns move together. The reverse is true.

For instance, returns from a company selling Ice cream and one selling Hot chocolate would probably have a negative covariance because they are sort after in different seasons which are inversely related being summer and winter.

From a Diversification perspective, it is best to use assets which have a negative covariance because it would ensure that should some assets go through a rough period, other assets will cancel them out by going through a good period.

The Covariance with other Assets in the portfolio is therefore more important to know.