Investment decisions are not taken in insolation; investors have to consider market dynamics and firm level factors to choose among various available securities. Among different factors affecting the investment decisions; risk and return are the significant one. Considering only one of these two factors will not lead to a rational decision; investors have to consider both for an optimal portfolio. Along with these factors; risk appetite of an investor cannot be separated from investment decision. The decision of risk taker investor is definitely different from a risk-averse investor.
Suppose you are a new investor in the market and you have two options for investing your money. On the basis of risk return analysis and your risk appetite you are required to select the one that suits you the most. Following information is available for the two stocks:
Stock A Stock B Returns Probability Returns Probability 29% 25% 30% 35% 28% 25% 29% 45% 30% 50% 28% 20% respectively
You are required to calculate:
Expected return on stock A
Expected return on stock B
Coefficient of variation for Stock A
Coefficient of variation for Stock B
On the basis of calculation of return and risk of both stocks; select the one according to your risk appetite (Note: First declare yourself either as risk-averse investor or risk taker investor). Now construct a portfolio of these two securities with proportion of 40% of your total investment in Stock A and 60% in Stock B; keeping all other information same (about risk and return) calculate risk of portfolio if covariance between two stock is -0.45. Compare the risk of your selected stock and the portfolio; do you think portfolio have diversified the risk?