Question

 

1. Friedman Manufacturing, Inc. has prepared the following information regarding two investments under consideration. Which investment is better, based on risk (as measured by the standard deviation) and return?

Common Stock A		Common Stock B
Probability	Return	Probability	Return
.20	12%	.10	4%
.50	18%	.30	6%
.30	27%	.40	10%
		.20	15%

2. “ More can be said about risk, especially as to its nature, when we own more than one asset in our investment portfolio.” Define risk and explain how risk is affected if we diversify our investment by holding a variety of securities?

Answer 1

Common Stock A

Mean computation

Probability	Return	Probability x Return
0.20	12.00%	2.40%
0.50	18.00%	9.00%
0.30	27.00%	8.10%
Mean return ---> Sum of (Probability x Return)	19.50%

Standard deviation computation

Probability	Return	Mean return	Deviation from Mean	Square of deviation from Mean	Probability x Square of deviation from Mean
0.20	12.00%	19.50%	-7.50%	0.56%	0.11%
0.50	18.00%	19.50%	-1.50%	0.02%	0.01%
0.30	27.00%	19.50%	7.50%	0.56%	0.17%
Step 1 : Sum of (Probability x Square of deviation from Mean)	0.29%
Step 2 : Square root of Step 1 ---> Standard Deviation	5.41%

Common Stock B

Mean computation

Probability	Return	Probability x Return
0.10	4.00%	0.40%
0.30	6.00%	1.80%
0.40	10.00%	4.00%
0.20	15.00%	3.00%
Mean return ---> Sum of (Probability x Return)	9.20%

Standard deviation computation

Probability	Return	Mean return	Deviation from Mean	Square of deviation from Mean	Probability x Square of deviation from Mean
0.10	4.00%	9.20%	-5.20%	0.27%	0.03%
0.30	6.00%	9.20%	-3.20%	0.10%	0.03%
0.40	10.00%	9.20%	0.80%	0.01%	0.00%
0.20	15.00%	9.20%	5.80%	0.34%	0.07%
Step 1 : Sum of (Probability x Square of deviation from Mean)	0.06%
Step 2 : Square root of Step 1 ---> Standard Deviation	2.46%

Risk is defined as the chance / probability that an outcome or investment's actual gains will differ from an expected outcome. It includes the possibility of losing some or all of an original investment.

Diversification is a strategy that reduces risk by allocating investments among various financial securities, instruments, industries, and other categories. It aims to maximize returns by investing in different areas that would each react differently to the same event whereby a possible loss would be be balanced by the potential gain from other investments in the basket.