Question

20. You are given the following information on two stocks and the market portfolio. Variance- Covariance Matrix Gamma Ltd Market Security Alpha Ltd Gamma Ltd Market Alpha Ltd 0.040 0.018 0.015 0.090 0.009 0.010 Assume that you have $50,000 available to invest. You form a portfolio by investing $20,000 in Alpha Ltd and the rest in Gamma Ltd. a. Compute the standard deviation of this portfolio. b. Compute the beta of each stock and the portfolio in (a) c. One of your clients, Ian Vest is considering investing in the above securities. Ian is quite a risk averse investor. He notices that Alpha Ltd and Gamma Ltd appear to be much more risky than the market portfolio, and he is quite concerned that Gamma Ltd is considerably more risky than Alpha Ltd. He concludes that he should not invest in Gamma Ltd's shares for that reason. Is Ian correct? What advice would you give him? Explain.

Can you explain part c please.

Thanks

Answer 1

We saw in part b) that beta of Alpha=1.5 and hence his observation that Alpha is more risky than market is correct. Beta of Gamma=0.9 hence his observation that Gamma is risky than market is wrong. Also his observation that Gamma is more risky than Alpha is wrong. We know higher the beta higher the risk.

Secondly, we should not base the decision solely on the risk. We should first see whether the stock is generating returns commensurate with its risk or not. So, howsoever risky the stock may be, if it is generating returns much higher than its required return, one should invest and if returns are lesser, do not invest. That is alpha should be the primary focus. Alpha is difference between expected return-required return). If alpha is positive, it is a good investment otherwise not. It may so happen that lower risky stock is not providing much alpha but higher stock is generating high alpha in this case higher risky stock is attractive.