Case Background
Daniel, a Starbucks barista and finance student, has RSUs (restricted stock units) that convert to shares after two years of continuous employment. Starbucks established the Bean Stock program, allowing employees to “participate in their financial success.” Daniel decided to invest his stock in the stock market after five years for higher returns. However, he understands that he must diversify his portfolio by investing in other companies to reduce risk.
Daniel approached me, an MBA student, for assistance in quantifying his risk and return. He was curious about the various companies’ risk profiles and whether the newly constructed portfolio provided the expected return to compensate for his risk. This case study will discuss Daniel’s situation, the “add value” strategies he can use, how risk and return for each stock and the SPY are estimated and compared, and conclude with advice on how Daniel should invest in stocks.
Market Risk
Investors frequently use a stock’s beta to gauge a security’s potential volatility. Running a regression model that compares the stock’s returns to the returns of an appropriate benchmark, like the S&P 500 Index, can be used to estimate it. A security’s returns are anticipated to increase by 14% if the benchmark rises by 1%, according to a beta value of 1.14. Therefore, the riskier the security is, the higher the Beta value. When deciding whether security belongs in a portfolio, beta can help investors determine their level of risk tolerance. Investors should consider the security’s beta before investing to determine the relative risk level they are willing to accept.
I calculated the beta for each stock in Daniel’s portfolio to determine its market risk. SPY had a beta of 1.0, GM had a beta of 1.14, XPO had a beta of 0.77, VZ had a beta of 0.75, and SBUX had a beta of 1.25. This means that GM is the most risky relative to the market, XPO and VZ are the least risky, and Starbucks is the most risky of the four. The equally weighted portfolio had a beta of 0.92.
Because of the risk diversification among the various assets and their respective weights, the portfolio risk is lower than that of individual stocks. A stock’s beta also indicates the expected return based on the market return (Handayani et al., 2019). If the market is expected to return 6%, a stock with a beta of 1.14 will be expected to return 6.84% (1.14 X 6%). As a result, stocks with higher betas provide higher returns.
The beta of a stock or portfolio also aids in determining the level of risk to which investors are exposed. Investors can limit their risk by investing only in stocks with lower betas, as riskier assets have higher betas (Handayani et al., 2019). Additionally, by investing in various stocks with various betas, investors can lower the overall risk in their portfolio. By purchasing both stocks with high betas and stocks with low betas, for instance, a trader can lower risk.
Market risk is generally a significant risk to consider when investing in stocks because it is challenging to diversify away. To reduce risk, investors should diversify their portfolios and be aware of the beta of their stocks. By understanding the level of risk associated with each stock in which they invest, investors can more effectively manage their risk and increase their potential returns.
Reference
Handayani, M., Farlian, T., & Ardian, A. (2019). Firm size, market risk, and stock return: Evidence from Indonesian blue chip companies. Jurnal Dinamika Akuntansi Dan Bisnis, 6(2), 171–182. Web.