Stocks: Risk Free 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?
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. From the investment instruments in the simulation, is it possible to construct a portfolio that is risk free? Explain.
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Solution Summary
In about 1000 words, including three references, this solution details the concept of stocks, discussing how the beta value is related to stocks and how risk can be managed, and should be dealt with. Examples are also provided to help make these concepts easier to understand.
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If stocks have a relatively high beta of 1.4 and is currently doing exceedingly well, why would it be better to have the stock in the portfolio be relatively low beta of 0.7 that has been recently under-performing? Have you entirely removed the potential risk of losses due to a declining stock market if the investments are diversified?
Beta measures a stock's volatility, the degree to which its price fluctuates in relation to the overall market. In other words, it gives a sense of the stock's market risk compared to the greater market. Beta is used also to compare a stock's market risk to that of other stocks. Investment analysts use a Greek letter to represent beta.
A beta of 1 indicates that the security's price tends to move with the market. A beta greater than 1 indicates that the security's price tends to be more volatile than the market, and a beta less than 1 means it tends to be less volatile than the market. Many utility stocks have a beta of less than 1, and, conversely, many high-tech Nasdaq-listed stocks have a beta greater than 1.
Essentially, beta expresses the fundamental trade-off between minimizing risk and maximizing return. Let's give an illustration. Say a company has a beta of 2. This means it is two times as volatile as the overall market. Let's say we expect the market to provide a return of 10% on an investment. We would expect the company to return 20%. On the other hand, if the market were to decline and provide a return of -6%, ...
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