Question

Sidney wants to construct a strategy that delivers alpha with respect to the CAPM. Which of the following strategies would you advise her to follow? Please select all that apply.

(a) Buy stocks with low idiosyncratic risk.

(b) Buy stocks with low systematic risk.

(c) Buy stocks with a high book-to-market ratio.

(d) Buy stocks of large companies.

Answer 1

As per CAPM approach return in any class of asset is associated with risk. This approach states asset having high risk have also high return.

Hence assets having low idiosyncratic risk or low systematic risk will not fetch high return. So first two approach is not advisable. Coming to approach (d) Buy stocks of large companies is also not advisable because it is always not possible that large companies will give high return. Take the case of few american compnies e.g. Enron,PaineWebber, compaq Kodak etc.

Hence Buy stocks with a high book-to-market ratio is best option available.