Question

Explain why a common stock should be evaluated in a portfolio context as opposed to being evaluated in isolation.

Answer 1

A portfolio is group of the securities which are added to a portfolio for the purpose. A portfolio consists of the group of discrete securities which add different risk and return to the portfolio. The portfolio manager evaluates individual security on merit of the benefit it would add to an existing portfolio.

Portfolio attains true diversification only when any addition reduces the portfolio risk or standard deviation and optimizes the return. When we look at a portfolio we look at cumulative return not individual stock returns.

When we evaluate individual security of a portfolio in isolation then sometimes it may appear meaningless but the real advantage of security can be very different when added to a portfolio.

Example: A stock yields a normal return in a normal economic scenario but in bad economy it delivers super normal returns. Then this security would worth a lot for a portfolio and can really be favorite of portfolio managers.