Question

You have the following data on three stocks:

                                Stock                  Standard Deviation                 Beta

                                   A                               18%    1.20

                                   B                                15%                                  0.89

                                   C                                12%                                  1.29

If you are a strict risk minimizer, you would choose Stock ____ if it is to be held in isolation and Stock ____ if it is to be held as part of a well-diversified portfolio.

Answer 1

Relevant risk measure to be used for isolation is standard deviation and for well diversified portfolio is beta

Hence choose Stock C if it is to be held in isolation and Stock B if it is to be held as part of a well diversified portfolio

Answer 2

In a well-diversified portfolio, the risk of the stock is designated by systematic risk or Beta of the stock. Lower the beta, lower is the risk that stock adds to a diversified portfolio. So, in this case, you would look to add Stock B (lowest beta).

In an isolated investment, the risk of the stock is designated by standard deviation which includes both systematic risks as well as unsystematic risk. The lower the standard deviation, the lower is the risk that stock adds to isolated investment. So, in this case, you would look to add Stock C (lowest standard deviation).