You are thinking of adding one of two investments to an already well diversified portfolio. Security A with expected return of 12%, standard deviation of 20.9%, and beta of 0.8. Security B with expected return of 12%, standard deviation of 10.1%, and beta of 2. If you are a risk averse investor, which one is the better choice?
a. Security A
b. Security B
c. Either security would be acceptable
d. Cannot be determined with information given
To determine which investment is the better choice for a risk-averse investor, we need to consider several factors including the expected return, standard deviation, and beta of each security.
The expected return measures the average return you can expect from the investment. In this case, both Security A and Security B have the same expected return of 12%.
The standard deviation measures the volatility or risk associated with an investment. A lower standard deviation implies lower volatility and thus lower risk. In this case, Security B has a lower standard deviation of 10.1% compared to Security A's standard deviation of 20.9%. Therefore, Security B is less risky.
Beta measures the sensitivity of an investment's returns to market movements. A beta below 1 indicates that the security is less volatile than the market, while a beta above 1 indicates greater volatility. Security A has a beta of 0.8, indicating that it is less volatile than the market, while Security B has a beta of 2, indicating it is more volatile.
Given that a risk-averse investor prefers lower risk investments, the better choice would be Security B. It has a lower standard deviation and a higher beta, suggesting it has lower risk (lower standard deviation) and is less sensitive to market movements (lower beta). Therefore, the answer is b. Security B.
By comparing the standard deviation and beta of the two investments, we can determine which one is better suited for a risk-averse investor.