Question

Compare and contrast:

(1) Describe the meaning of beta, standard deviation and coefficient of variation.

(2) How each of them can be used to stock investment? For example, how you select an investment using each of these three measures? (this is an open question, the answer will be graded based on student's understanding on each concept)

Answer 1

1]

Beta is systematic risk. It the sensitivity of the stock's returns to the returns of the overall market. Specifically, it the percentage change in stock returns for a 1% change in the overall market.

Standard deviation is a measure of total risk of a stock. It includes both systematic risk and firm-specific risk.

Coefficient of variation = (standard deviation of stock / average return). It is the risk per unit of return. A lower coefficient of variation means that the stock has lower risk, per unit of return.

2]

Beta is higher for cyclical stocks, and lower for non-cyclical stocks. If the overall economy is expected to do well, and the overall market is expected to do well, then stocks with high beta (beta > 1) will outperform the overall market and stocks with low beta (beta < 1) will underperform the overall market. Conversely, if the overall economy is expected to be in a downturn, and the overall market is expected to fall, then stocks with high beta (beta > 1) will underperform the overall market and stocks with low beta (beta < 1) will outperform the overall market. Hence, when selecting stock investments, an analysis must be done on the overall market expectations. If the market is expected to rise, then stocks with high beta must be selected. If the market is expected to fall, then stocks with low beta must be selected.

Standard deviation measures overall risk. Stocks with lower standard deviation have lower overall risk. Stocks with higher standard deviation have higher overall risk. Therefore, the stock's standard deviation must be compared to the risk-return objective of the investor, and stocks should be selected accordingly.

Coefficient of variation is the risk per unit of return. If two stocks have the same expected return, then the stock with lower standard deviation must be selected because the same return can be earned with lower risk. Similarly, if two stocks have the same standard deviation, then the stock with higher expected return must be selected because a higher return can be earned with the same level of risk. Coefficient of variation quantifies this concept.