Suppose an investor has mean-variance preferences given by U(p) = E?rpl – zyo , where y is risk aversion. She is considering investing in only one of the following three assets: a risk-free asset with expected return of 7%, a stock X with an expected return of 12% and a standard deviation of 18%, or a portfolio P that invests 30% in stock A, 60% in stock B, and the rest in the risk-free rate. Suppose E[ra] =9%, E[rb] = 10%, 0A = 20%, Op = 25%, and the correlation between A and B is –0.4. Risk TB OA OB B aversion is y= 2. Which of the three should the investor choose?
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