Question

You are thinking of adding one of two investments to an already well-diversified portfolio.

Security A Security B

Expected return=12% Expected return= 12% Standard deviation of returns 20.9%/ Standard deviation of returns = 10.1%

Beta = 0.8 Beta = 2.1

If you are a risk-averse investor, then:

Answer 1

Answer: A risk-averse investor should invest in Security A since it has a lower Beta.

Explanation:

Standard deviation reflects total risk. Total risk is the sum of systematic and unsystematic risk. Systematic risk is an inherent risk that exists in the entire stock market. On the other hand, the unsystematic risk exists at a firm level and is influenced by factors within the company.

Beta is a measure of systematic risk only. In an efficient market, the return is affected by systematic risk.

As given in the question, the investor already has a well-diversified portfolio and thus systematic risk should be used to make investment decisions. Therefore since beta is a measure of systematic risk, a stock with lower beta should be selected by a risk-averse investor. Since Security A has a lower Beta than Security B hence security A should be chosen.

However, if you have no portfolio to start with, unsystematic risk is more relevant to you. In this case, the standard deviation is your friend because it accounts for both risk types. However in this question, since the investor already has a well-diversified portfolio hence we should invest based on the respective Beta's of each stock.

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