“ As a financial advisor, you are assigned a new client who is considering investing in one of two stocks, A or B. The table below shows information about the performance of stocks A and B last year.”
Return | Standard Deviation | |
Stock A | 15 % | 8.3% |
Stock B | 14% | 2.1% |
“ As a financial advisor, are there factors other than return and risk that should be considered in making this decision?”
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Obtaining a large dataset on the history of both stocks should be factored if available to assess the performance of the stock in the past. Such an assessment could be used to forecast the performance of the stock in the future. Using monthly or past yearly returns on the stock to evaluate the past variance of each stocks' returns is also an important aspect. Secondly, the coefficient of variation is another factor that could be used to make a financial-based decision. Another factor to be considered is the motive of the investor with either short or long terms investment.
“ Based on these factors, what stock would you recommend to the client?”
The recommendation is stock B for a risk averse client and stock A for high risk-taking client.
“ What reasons will you convey to your client to justify your decision in recommending this stock?”
The reason to justify such a recommendation on stock B would be the standard deviation and percentage of return of stock B. Due to the difference between stock A and B with 1%, then different measures should be considered such as the standard deviation. Standard deviation is used to examine the data spread from its average or mean (Kumar & Lim, 2008) . Volatility is explained using the standard deviation of returns. Stock A has an increased standard deviation which means that it has more volatility. The stock could move from the average return rate which could lead to either a big loss or a higher gain. From an investment point, the stock with the least standard deviation that is close to 0 is the best selection, in which case is stock B with 2.1% and not stock A with 8.3%. The standard deviation close to 0 would make the client have an increased expectation on the stock returns and not deal with a return that could drop significantly. Therefore, stock B has a risk factor lower than that of stock A.
The second reason is that the coefficient of variation for B is less than A. Therefore, the preference would go to stock B as shown in the table below:
| Type of stock | Return | Standard Deviation | Coefficient of variation |
| Stock A | 15% = 0.15 | 8.3%= 0.083 | Standard Deviation divided by Return =0.083/0.15 = 0.55 |
| Stock B | 14%= 0.14 | 2.1%= 0.021 | Standard Deviation divided by Return =0.021/0.14 = 0.15 |
From the table, the risk will be more for the return based on the coefficient of variation. The coefficient variation helps understand the investment decision made (Klos et al., 2005). The risk of investing in stock A is higher while lower when investing in stock B.
On the other hand, if the client is a high-risk taker and considers short term investment, they would go for stock A. The reason is that the client can invest and sell the stocks any time they want with the 8.3% variation in the standard deviation. In such a situation, they could have huge returns compared to stock B over the short run.
“ How will this recommendation impact the client?”
The recommendation will have a positive impact on the client through reassurance that the financial advisor is after the best possible returns and interests. The client will also understand the risk that they are taking when given the standard deviation for the various types of stocks. Also, the client will get to comprehend the impact of the coefficient of variation on the risk taken, and the percentage returns to expect. The client will also understand what type of stock is safer when making investment decisions. The stock options would offer the client incentives to determine risky projects (Rajgopal & Shevlin, 2002). Having all this information would help the client select the best possible stock which could be comfortable for the investment. The recommendation would help the client know whether they could be risk-averse or risk-takers depending on either long-term or short-term goals.
References
Kumar, A., & Lim, S. S. (2008). How do decision frames influence the stock investment choices of individual investors? Management science, 54(6), 1052-1064.
Klos, A., Weber, E. U., & Weber, M. (2005). Investment decisions and time horizon: Risk perception and risk behavior in repeated gambles. Management Science, 51(12), 1777-1790.
Rajgopal, S., & Shevlin, T. (2002). Empirical evidence on the relation between stock option compensation and risk taking. Journal of Accounting and Economics, 33(2), 145-171.
