Diversification in Stock Portfolios
Assignment # 3
Dr. James Glenn
May 15, 2011
Financial Management- FIN 534-5016
The expected return on stocks is established as the computation for the return of a security based on the average pay off expected where as the volatility of stocks is the standard deviation of a return. The relationship between risk and return is examined by historical data for publicly traded securities. As investors in the stock market we learn that stocks are riskier investments than bonds, but they also have earned higher average returns. By holding a portfolio containing different investment, investors can eliminate risk that is specific to individual securities.
There is no clear relationship between the volatility and return of ...view middle of the document...
Given the following scenario of risk free investment, we as financial managers must decide what is best for our investors who chose us to invest their money and stocks in the best portfolios that will generate the most pay out for our investments.
Consider the following two, completely separate economies. The expected return and volatility of all 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 price of other stocks. Assuming you are risk-averse and you could chose one of the two economies in which to invest, which one would you choose? Explain.
In my opinion the best one that would be be more feast able for me would be for me as a risk-averse investor would be the economy in which the stock return are independent because this risk can be diversified away in a large portfolio.
Only that risk that cannot be eliminated by holding a large portfolio determines the risk premium required by investors. The risk premium for diversifiable risk is zero, so investors are not compensated for holding firm specific risk. Risk-averse investors will demand a premium to invest in securities that will do poorly in bad times. As financial managers we are investors investing money or stock on behalf of our investors or companies shareholders. When we make new investments we as financial managers must ensure that we have diversified our stock with a minimum risk and that the investments have a positive NPV.
Berk, J., & DeMarzo, P. (2011) Corporate Finance: The Core, 2010 Custom edition (2nd Ed.) Boston, Pearson Education