Introduction:
In the world of stock investments, understanding risk is crucial. Beta is a measure of a stock's volatility, indicating its sensitivity to market movements. By calculating the portfolio beta, investors can evaluate the overall risk associated with their investment mix. In this article, we will analyze a stock portfolio consisting of four stocks, each with different betas.
Portfolio Composition:
Our hypothetical portfolio includes four stocks: Q, R, S, and T. These stocks are allocated 15 percent, 25 percent, 40 percent, and 20 percent of the total portfolio, respectively. To calculate the portfolio beta, we need to consider the individual betas of each stock.
Beta Calculation:
The beta of stock Q is 0.75, stock R is 0.87, stock S is 1.26, and stock T is 1.76. To calculate the portfolio beta, we multiply the weight of each stock by its respective beta and sum the results. Therefore, the portfolio beta can be calculated as follows:
Portfolio Beta = (Weight of Q * Beta of Q) + (Weight of R * Beta of R) + (Weight of S * Beta of S) + (Weight of T * Beta of T)
Calculating the Portfolio Beta:
Using the given weights and betas, the portfolio beta can be calculated as:
(0.15 * 0.75) + (0.25 * 0.87) + (0.40 * 1.26) + (0.20 * 1.76) = 0.1125 + 0.2175 + 0.504 + 0.352 = 1.186
Interpreting the Portfolio Beta:
The portfolio beta of 1.186 indicates that the portfolio is more volatile than the market average. A beta of 1 suggests the portfolio will generally move in line with the market, while a beta greater than 1 indicates higher volatility. Therefore, the portfolio beta of 1.186 suggests that the portfolio is expected to experience larger price fluctuations compared to the overall market.
Diversification Impact on Beta:
Diversification plays a vital role in managing portfolio risk. By allocating investments across different stocks with varying betas, investors can potentially reduce the overall portfolio beta. In this scenario, the portfolio beta of 1.186 suggests a moderate level of risk, indicating that the portfolio's returns may be impacted by market movements to a greater extent than the market average.
