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Beta and Risk

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1) If one of your stocks has a relatively high beta of 1.4 and is currently doing exceedingly well, why would you want a stock in your portfolio with a relatively low beta of 0.7 that has been recently under-performing? By diversifying your investments according to betas, have you entirely removed the potential risk of losses due to a declining stock market?

2) If you are relatively risk adverse, would you require a higher beta stock to induce you to invest than the beta required by a person more willing to take risks? Explain. Is it possible to construct a portfolio that is risk free? Explain.

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Solution Summary

The solution evaluates the risk of two stocks based on their beta coefficients and recommends whether they should be included in a portfolio

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1) If one of your stocks has a relatively high beta of 1.4 and is currently doing exceedingly well, why would you want a stock in your portfolio with a relatively low beta of 0.7 that has been recently under-performing? By diversifying your investments according to betas, have you entirely removed the potential risk of losses due to a declining stock market?

The stocks are risky because the returns are uncertain. There is a spread of possible returns. The risk of any stock has two parts: unique risk (or unsystematic risk) that is peculiar to that stock and market risk (or systematic risk) that is associated with market wide variations (advances and declines of the market). An investor can eliminate unique risk (or unsystematic risk) by holding a well diversified portfolio. It is not possible to eliminate market risk (or systematic risk).

Thus it makes sense to have different stocks in the portfolio for the purpose of diversification which eliminates the unique risks of holding ...

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