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 individual stocks, larger stocks tend to have lower overall volatility, but even the largest stocks are typically more risky than a portfolio of larger stocks. All stocks seem to have higher risk and lower returns than would be predicted based on extrapolation of data for larger portfolios. Risk aversion is measured as the additional marginal reward an investor requires to accept additional risk...Risk is being measured as standard deviation of the return on investment the square root of its variance. The goal of an investor is to find the portfolio that generates the steepest possible line when combined with the risk-free investment. 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...