Risk Management Simulation
Essay Preview: Risk Management Simulation
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If one of your stocks has a relatively high beta of 1.4 and is currently doing exceedingly well, why would you want a stock in your portfolio with a relatively low beta of 0.7 that has been recently under-performing? By diversifying your investments according to betas, have you entirely removed the potential risk of losses due to a declining stock market?
For the first question, the simple answer is that by diversifying your stock holdings, a more conservative approach is taken. A stock with a low beta at 0.7 is somewhat of a higher risk in losses. The tendency in this investment thought is that a recently under-performing stock, the future may hold the opposite, an increase in return. While the 1.4 beta stock has high returns, the potential for losses is greater than in the 0.7 beta stock. Having a myriad of investments in your portfolio can help to weaken the blow when the higher beta stock plummets.
For the second question, only by diversifying your investments due to betas, you have not entirely removed the potential risk of losses due to the decline in the stock market. The definition of risk backs up this claim that truly anything can happen.
If you are relatively risk adverse, would you require a higher beta stock to induce you to invest than the beta required by a person more willing to take risks? Explain. From the investment instruments in the simulation, is it possible to construct a portfolio that is risk free? Explain.
Seemingly, someone more conservative in the risk-taking department would tend to require a lower beta stock. This is explained in detail below, referencing an article on Indias beta stock information.
I feel that, in reference to the simulation, there is no real way to construct a portfolio that is risk-free. There are so many other variables that one cannot control just by seeing stock numbers. September 11 is the most glaring example that comes to mind.
“The total risk of a stock is measured by its standard deviation. In relation to a market, it is its co-variance with the market. If this covariance is standardized for the covariance of the market we get the beta value, which. Beta value is a standardized measure of covariance of return of an asset and that of the market.
Beta is a measure of non-diversifiable risk. We can say that the beta of a stock measures the sensitivity of the stock with reference to a broad based market index.
The broad based index for instance, in India, could be the Sensex. We can understand what beta indicates by considering a few numbers. For instance, a beta of 1.2 for a stock would indicate that this stock is 20 per cent riskier than the Index. Similarly, a beta of 0.9 would indicate that this stock is 10 per cent (100-90) less risky than the Index. And, of course, a beta of one would mean that the stock is as risky as the stock market index.
This has two simple implications:
a) Beta is the measure of a stocks volatility with reference to the market index. Put another way, this would mean that the beta of a stock indicates the sensitivity of a stock to changes in the returns from the stock market. If the stock market as a class (measured by the Index) changes by 5 per cent, a stock with a beta of 1.2 should change by 5 x 1.2 = 6 per cent
b) Expected risk premium of any stock is beta times the market risk premium: An investor gets extra reward for taking risk. This is called risk premium. If the stock market as a class (measured by the Index) gives a risk premium of, say, 10 per cent and the beta of a stock is 1.2 the risk premium from this stock ought to be 1.2 times, that is, 12 percent.
The beta value of a stock can be any number. If the beta value is greater than one, we call it a high beta stock. Such stocks are riskier than the “stock market”. They move faster than the movement in the stock market. If the market goes up, this stock goes up faster. If the market falls, this