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Question - Suppose you have recently accepted a new job and are setting up your retirement allocations within the firm's 401k plan. The plan options contain two risky mutual funds, A and B. You may assume that all fees are the same across the two funds. Fund A has an expected return of 6% and the standard deviation of returns is 12%. Fund B has an expected return of 7% and the standard deviation of returns is 15%. The correlation between returns on the two funds is 0. The plan also contains a Treasury fund which provides a risk-free return of 3%.
A. Suppose you can only invest in one of the two risky mutual funds (A or B), but can combine it with the Treasury fund in any proportions you wish. Which of the two mutual funds would you choose and why.
B. Maintaining the restrictions on your investment choices from the last question, what is the best expected return you could achieve if you set up a portfolio with a standard deviation of returns equal to 10%?
C. Would you prefer to be able to form a risky portfolio of funds A and B before combining the resulting portfolio with the Treasury fund to achieve your target risk of 10%? Clearly explain why or why not.
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