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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?
Beta is the measure of risk of a portfolio of
stocks. An average stock will move up and down
with the general market, as measured by the NYSE,
S&P 500 or some other such index. Such a stock
can be said to have a beta of 1.0, meaning that
it is moving up or down in synchronization with
the broad market averages.
Therefore this stock will be considered just as
risky as the market averages. A stock with a beta
higher than 1.0 would mean that it is more risky
than the market average, and a stock with a beta
of less than 1.0 would mean that it is less risky
than the market average. Normally, the average
investor will have a mix of stocks, some with
beta more than 1.0 and some less than 1.0. This
would enable him to diversify and thus reduce
the overall risk. If one of the stocks has a relatively
high beta of 1.4, no matter if it is doing exceedingly
well, the above average returns to the investor
cannot last indefinitely and they are bound to
reduce. By including a stock with a relatively
low beta of 0.7, no matter it is has been under-performing
at the moment, the investor would have diversified
his risk, hopefully reducing the overall risk.
The total risk would be reduced if the returns
on the stocks ran counter-cyclically to each other.
So care must be taken to see that the returns
on the stocks chosen are relatively counter-cyclical
i.e. returns on Stock 1 rise when returns on Stock
2 fall, and vice versa. Theoratically, if two
such stocks are combined the returns would be
relatively riskless. It is rather difficult to
find stocks whose returns are negatively correlated-
it takes a consideration of sectors and also historical
analysis.
However by diversifying the investments according
to betas, we would only be taking care of the
diversification risk The factors that affect stock
price are various; while there is the general
feeling that stocks move up and down in line with
the performance of the economy, there are also
events unique to the company or sector of the
stock concerned that will effect the stock price
and future returns. We cannot totally eliminate
risk by combining stocks with low and high betas,
such as losses due to a declining stock market.
However if we have chosen our stocks wisely, we
would be making higher than average returns even
in a falling market. For even in a generally declining
market, all stocks in all sectors do not decline
at the same time or at the same rate. Some stock
can rise even in a generally falling market. Combining
stocks with high and low betas can hopefully ensure
better returns. There is no way to eliminate total
risk. Beta takes care of only diversifiable risk,
not total risk.
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.
The element of risk always implies some return
for taking that risk. A risk averse investor has
a low appetite for risk. Therefore he would prefer
lower but consistent returns on his investments.
A person willing to go for higher returns would
ordinarily be induced to take higher risks in
the hope of getting higher returns. Therefore
the risk averse investor would prefer that the
beta of his stocks are as close to 1.0 as possible.
He would also most likely invest in a fewer number
of stocks. On the other hand, the risk taker would
prefer to invest in stocks with higher betas,
providing above average returns. He would usually
have a bigger portfolio, and would seek to combine
investments with low and high betas, so that his
portfolio is diversified and the combination brings
about an overall beta of close to 1.0. Technically,
it is possible to construct a portfolio that is
relatively risk free- this would occur when the
returns of the stocks are negatively correlated,
so that when one’s return is rising, the
other is falling and they counterbalance each
other. But as explained, this would only take
care of diversification risk. Total market risk
cannot be eliminated.
Stock price and returns would be affected both
by the state of the economy and the unique events
in the sector or company concerned.
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