Risk Reward Behavior and Stock Portfolio Diversification
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You are a risk-averse investor who is considering investing of two economies. The expected return and volatility of stocks in both economies is the same. In the first economy, all stocks move together - in good times all prices rise together and in bad times they all fall together. In the second economy, stock returns are independent - one stock increasing in price has no effect on the prices of the stocks. Which economy you chose to invest in?
Explain.
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This solution discusses risk reward behavior and diversification in stock portfolios.
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Risk Reward Behavior and Stock Portfolio Diversification
Portfolio diversification aims to spread the said portfolio over many investments to avoid excessive exposure to any one source of risk. Specifically, the risk that diversification wishes to minimize is the risks attributable to firm-specific risk or non market risk in contrast to non diversifiable risk which is systematic or market risk. Thus, no matter how diversified a portfolio is there is still a risk associated to the portfolio, the non diversifiable one.
Portfolio and even asset diversification has never been in the spotlight as it is today. Diversification is one of the most painful lessons investors learned during the recent financial crisis. Specifically, the financial crisis thought investors and investment managers alike the need to ...
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