Diversification in Stock Portfolios. 

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Assignment # 3. Diversification in Stock Portfolios.

Strayer University
Tim Creel, CPA,CMA,CIA, Professor
Finical Management-FIN 534
5/28/11

You are a risk averse investor who is considering investing in one of two 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 prices of other stocks. Which economy would you choose to invest in? Please explain.

A risk averse investor is a person who is reluctant to accept a bargain with an uncertain payoff rather than another bargain with more certain, but possibly lower, expected payoff.
Thus, it can be said that risk averse person would be more inclined towards investment in bank’s fixed deposit than in uncertain returns of a stock market. But, if I being a risk averse investor and given a choice to invest in one of the 2 economies then I would select the second economy where stock returns are independent- one stock increasing in price has no effect on the prices of the other stocks.

The first economy would result in uncertain returns as the prices would rise with the market and would fall with the market and to predict the market would be a risky task for a risk averse person. Relatively, investment in second economy would be less risky as the movement in stock prices would be independent of each other and the market.

The expected return and volatility of all the stocks are same in both the economies but their movement with the market is the deciding factor to invest in the two economies. Beta is an important tool here to make the investment decisions. Beta of a stock or portfolio may be defined as a measure of relation of its returns…...

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