FIN 300 Fundamentals of Finance Risk and Return Pt. 3 Chapter 7 1 FIN 300 - Risk and Return Pt. 3
Beta vs. Standard Deviation • Assuming that we are already well-diversified – that we already own, practically speaking, at least 25-30 uncorrelated stocks or shares in an S&P 500 Index mutual fund – We have diversified (or, smoothed) away the firm- or industry-specific variation (risk) in the stock investment – However, even if we owned the entire market, we would still be exposed to some risk (variation) due to the systematic risk that affects all stocks to some extent – Because we are diversified, we are no longer exposed to the total (standard deviation) risk of the stock – However, we are still exposed to the remaining, systematic (or, beta) risk of the stock FIN 300 - Risk and Return Pt. 3 2
Using Beta to Measure Risk • Nevertheless, we can still evaluate each stock (on its own merits) as to how well its return compensates for risk • But, we no longer use standard deviation as the measure of an individual stock’s risk • Instead, we use the beta of the individual stock • Beta is a measure of a stock’s systematic risk exposure that can’t be diversified away no matter how many additional stocks we own • When we compare stocks’ risk we compare them on the basis of beta • Beta measures the extent to which the stock’s variation co- varies with that of all of the other stocks in the market FIN 300 - Risk and Return Pt. 3 3
CAPM and Beta • We have a model that relates the beta of a stock to its expected return • That model is the Capital Asset Pricing Model (known as the “ CAPM ”) • Using the CAPM, we can plug in the beta and a few other variables to calculate the return of a stock • So, assuming we are diversified, it is no longer a matter of a stocks return vs. it’s total (standard deviation risk) – It’s now a matter of evaluating a stock’s return vs. it’s beta risk!
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