Question

The following figure shows plots of monthly rates of return and the stock market for two stocks.

a. Which stock is riskier to an investor currently holding her portfolio in a diversified portfolio of common stock?

b. Which stock is riskier to an undiversified investor who puts all of his funds in only one of these stocks?

Short answer

a. Stock B's systematic risk is greater

b. Stock A is the riskiest

Step-by-step solution

Evaluation of riskier stock in a diversified portfolio

The risk of the diversified portfolio consists primarily of systematic risk. Beta measures systematic risk, which is the slope of the security characteristic line (SCL).

The two figures depict the stocks' SCLs. Stock B's SCL is steeper, and hence Stock

B's systematic risk is greater. The slope of the SCL, and hence the systematic risk

of Stock A, is lower. Thus, for this investor, stock B is the riskiest.

Evaluation of riskier stock in an un-diversified portfolio

The undiversified investor is exposed primarily to firm-specific risk. Stock A has a higher firm-specific risk because of the deviations in the observations from the

SCL is larger for Stock A than for Stock B. Deviations are measured by the vertical distance of each observation from the SCL. Stock A is, therefore, the riskiest to this investor.