Assuming both portfolios are fully diversified investors sho

Assuming both portfolios are fully diversified, investors should expect Portfolio B to have a higher return under the CAPM. Do you agree or disagree with this statement?

Briefly Explain.

Portfolio A

Portfolio B

Systematic Risk

1.0

1.0

Specific Risk for each individual security

High

Low

Solution

Under the CAPM, the only risk that investors are compensated for bearing is the risk that cannot be diversified away (systematic risk). Because systematic risk (measured by beta) is equal to 1.0 for both portfolios, an investor would expect the same rate of return from both portfolios A and B. Moreover, since both portfolios are well diversified, it doesn\'t matter if the specific risk of the individual securities is high or low. The firm-specific risk has been diversified away for both portfolios.

Thanks