How to Create a Diversified Stock Portfolio

Harness the Power of Beta and the Capital Asset Pricing Model

By: John Cousins

Narrated by: Virtual Voice

The surest way to become wealthy is to save money and invest it in the stock market. The stock market has been the greatest wealth generator of the past century. Here are two tools you should be familiar with in order to reduce risk and increase your returns through diversification and portfolio theory. Beta and the Capital Asset Pricing Model are also used to calculate the cost of equity. This is a method to derive a meaningful discount rate for discounting the future cash flows and valuing income-producing assets. Attention Entrepreneurs These tools can be used to create a rational valuation for a startup seeking early stage equity financing.

Every company has different products and services, customers and competitors, technologies, and employees. These unique circumstances and situations mean that every company listed on the stock market has a different risk profile.

How can we measure and compare the relative risk of different stocks?

The equity risk premium is the excess return that investors in the stock market require above and beyond the interest rate provided by U.S treasury bonds. U.S. treasury bonds are the de facto risk-free alternative because they are backed by the government's ability to pay.

Investors think in terms of a risk-reward tradeoff. The additional anticipated return compensates investors for taking on the higher risk of investing in stocks.