Standard Deviation As a financial advisor, you are assigned a new client who is
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Question
Standard Deviation
As a financial advisor, you are assigned a new client who is considering investing in one of the above two stocks, A or B.
The table above shows information about the performance of stocks A and B last year.
1) As a financial advisor, are there factors other than return and risk that should be considered in making this decision?
2) Based on these factors, what stock would you recommend to the client?
3) What reasons will you convey to your client to justify your decision in recommending this stock?
4) How will this recommendation impact the client?
Standard Deviation
Stock A 15% 8.30% Stock B 14% 2.10%Explanation / Answer
1. While making investment decision, there are other factors other than risk and return, they are attitude of investors whether they are risk averse or not, other charges or loads on investment, downside risk, past performance of the stock, stability of the return, quick disposal facility i.e liquidity of stock etc.
2. To select between Stock A or Stock B, it is better to calculate Covariance for both the stocks as it measures the risk in absolute terms ie. what is the risk of stock for every 1% return.
Covariance = Standard deviation/Mean
Covariance of Stock A = 8.30%/15% = 0.55
Covariance of Stock B = 2.10%/14% = 0.15
Stock B is the best as its covariance is the lower than Stock B. In the case of Stock A there is a risk of 0.55 for every 1% of return,where as in case of Stock A, the risk is only 0.15 for every 1% of return;Hence, Stock B is the best choice,so I recommend Stock B
3. The reasons for which I recommend stock B is that of lower risk, and when compared to Stock A, the return is almost the same and this return is greater than risk free rate and consistency of return exists than Stock A
4. The client will get stable return with low risk, so he also may prefer Stock B rather than Stock A unless he is risk lover.
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