Question

1) Please describe the meaning of diversification. How does diversification reduce risk for the investor? 2) How do investors measure the risk of individual common stocks?

2) How do investors measure the risk of individual common stocks?

Answer 1

1)

Diversification means allocating funds to various financial instruments which have different risk profiles.

Diversification is achieved through selecting stocks which have low correlation with existing portfolio. The low correlation means that stock to be added in portfolio will not have same risk profile as existing one. Stock with low correlation with existing portfolio will achieve true diversification hence, diversification reduces the risk of the portfolio of an investor.

2)

Individual stock risk is measured by its beta. Beta states that the riskiness of stock in relation to market portfolio. Beta of 1 implies stock equally risky as market portfolio. Beta of more than 1 means stock is riskier than market portfolio. Beta of less than 1 means stock lesser riskier than market portfolio.

Beta of more than 1 would make sense to invest in stock otherwise individual for go for investment in diverse market portfolio.

Beta = Covariance of Return of (Stock, Market) / Variance of Market