Question

Why is Beta the correct measure of risk and why do you get more return when you can just diversify?

Why do you get greater returns by bearing a greater risk when it comes to Beta stocks?

What are the main criticisms of Effecient Market hypothesis?

How can you take advantage of these criticism?

How does it justify its claim and show evidence that doesnt support the capital asset pricing model?

Answer 1

1.
Beta represents the market risk, that cannot be either reduced or eliminated. So, investors has to take care of this risk as it impacts upon the return of the investment. Risk such as war, inflation risk and forex risk fall under the category of market risk. This risk measures the volatility in return of the investment w.r.t. the market. So, beta is the right measure of the risk.
With the help of diversification, the unsystematic risk can be reduced with the help of diversification. The examples of unsystematic risk is business risk, project risk, and management risk. These risks are reduced when investments are done in more number of companies. It means that the impact of unsystematic risk associated with any one company is reduced and return is stabilized. It shows that with diversification, the return is improved at that particular level of risk.

2.
Beta shows a relationship between stock return and market return. If Beta of a stock is greater than 1, then it means that stock is high risk stock. For example, if Beta of stock is 1.5 then it means that if market grows by 1% then Stock return grows by 1.5%, so growth in stock return outsmarts market return if the stock has beta with value of more than 1.
Hence, it is concluded that stock with higher beta, will fetch higher return.
In CAPM model also,
Expected return of stock = Risk free return + Beta * risk premium
Hence, bigger the size of beta, will lead to bigger the size of the expected return of the stock.

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