Finance Discussion Question 6

Hi Folks – This week we are going to use the math for computing a weighted average and apply it to the investment model we learned about last week, the CAPM.  Using a weighted average, you can manipulate the expected risk and return of a portfolio of stocks to match your personal risk tolerance.  If you have a stock that has a relatively low Beta, you can use it to reduce the overall risk of a portfolio, even if the returns themselves are not super fantastic. For example, if you were to pair Ford with another higher beta stock, Ford’s low beta would help to off-set the risk of the other stock. Here is how to compute the beta and expected return of a portfolio…

% of portfolio

Beta

Contribution to portfolio Beta

Expected Return (CAPM)

Contribution to Portfolio Return

Ford

50%

1.03

.50 x 1.03 = 0.515

9.7%

.50 x .097 = .0485 = 4.85%

riskier stock

50%

2.2

.50 x 2.2 = 1.1

15.3%

.50 x .153 = .0765 = 7.65%

Portfolio Beta

.0.515 + 1.1 = 1.6

Portfolio Return

4.85% + 7.65% = 12.5%

As you can see, the addition of Ford to a portfolio containing a riskier stock decreases the overall risk of the investments and still provides a respectable return of 12.5%.

Requirements

Complete the following tasks for this assignment: 

• Visit the following website and take the Investment Risk Tolerance Quiz.

Make a note of your results.  You will use this information for this activity.

• Revisit your post from last week on the CAPM.  Review the Beta and the Expected return for the stock you chose.  Evaluate how risky this stock seems in relation to your risk tolerance profile.  In other words, if you are a conservative investor, but the stock you selected last week had a very high Beta, then you will want to reduce the risk of owning this stock by pairing it with a low Beta stock.
• Once you have decided whether or not you need to increase or decrease risk, go back to YahooFinance and research some possible stocks to add to your portfolio.  Identify 1 or 2 stocks that you think would bring the overall risk of your portfolio within a comfortable range.  Use this FINC 331 Wk 6 Discussion Table.xlsx to help you compute the portfolio weighted averages. 
  • Place the stock you used last week in the row marked “stock #1”.
  • Enter the information for stocks #2, and #3 if using a third.
  • Remember to adjust the portfolio weightings to reflect the number of stocks you have chosen.  If you have two stocks, then the weighting is 50% each.  If you have three, then it is 33.34% each.
  • Compute the Portfolio Beta and Portfolio Expected return.  Use the example above to help you.
• Tell us what you have learned about your risk tolerance profile and the stocks you selected.  Be sure to copy and paste your Table into your post so that we can see your calculations.

Remember that main thread posts are due Sunday at midnight.  Two reply posts are due Tuesday by midnight.

You must start a thread before you can read and reply to other threads 

Required Reading 

 http://oer2go.org/mods/en-boundless-static/www.boundless.com/finance/textbooks/boundless-finance-textbook/index.html 

 http://www.teachmefinance.com/costofcapital.html