Risk and Return Risk and return are the fundamental parameters of any investment. While some investments may present greater risk they are countered by a higher rate of return. The vice versa holds true as well, less risk corresponds to a lower return. One way to measure risk is through calculating the standard deviation of returns. This measurement tells an investor how volatile or risky an investment is, by providing the investor with a range of possible outcomes based on the stocks expected return. Therefore, the lower the standard deviation percentage the less risk a given investment has. Moreover, when risk is being analyzed for more than one investment in a portfolio, a correlation of returns measurement is used. This calculation determines whether or not the investments respond similarly (+1) or conversely to market changes (-1). The closer the correlation is to -1 the more diversified the investment is resulting in less risk (Hirt, Block & Basu, 2006). Combined, these measurements provide investors with the tools necessary to analyze an investments risk and determine the best investment choices.
Comparing Investments Comparing the investments in the chart above, an investor can use the standard deviation and correlation of returns to determine the given risk of the investments, as well as which investment choice would yield a better return. With the information provided a portfolio made up of equal parts B and C will ultimately be less risky than a
The most important insight we get is that in a diversified portfolio, the contribution to portfolio risk of a particular security will depend on the covariance of that security’s return with those of other securities.
Advisors and investors would do well to pay as much attention to the expected volatility of any portfolio or investment as they do to anticipated returns. Moreover, all things being equal, a new investment should only be added to a portfolio when it either reduces the expected risk for a targeted level of returns, or when it boosts expected portfolio returns without adding additional risk, as measured by the expected standard deviation of those returns. Lesson 2: Don’t assume bonds or international stocks offer adequate portfolio diversification. As the world’s financial markets become more closely correlated, bonds and foreign stocks may not provide adequate portfolio diversification. Instead, advisors may want to recommend that suitable investors add modest exposure to nontraditional investments such as hedge funds, private equity and real assets. Such exposure may bolster portfolio returns, while reducing overall risk, depending on how it is structured. Lesson 3: Be disciplined in adhering to asset allocation targets. The long-term benefits of portfolio diversification will only be realized if investors are disciplined in adhering to asset allocation guidelines. For this reason, it is recommended that advisors regularly revisit portfolio allocations and rebalance
“The Benefits of diversification are clear. Portfolio theory has played a crucial role in explaining the relationship between risk and return where more than one investment is held. It also enables us to identify optimal and efficient portfolios.”
A short-term investment objective is defined as one that will be accomplished within a period of two to five years.
With attention to the previous information given, the principle of risk-return tradeoff is based on the thought that individuals are opposed to taking risk, meaning individuals would prefer to get a certain return on their investment rather than risking and getting an uncertain return. (Titman, Keown, & Martin, 2014) This principle tells us that investors will receive higher returns for taking on a bigger risk however; a challenge often seen in investors is how to calculate the tradeoff between risks and return with riskier investments. A higher expected rate of return is not always a higher actual return.
The beta of a stock measures the risk of the stock. However, is not not just any risk, it is the risk that you should expect to be rewarded for
Throughout the Stock Market Game experience, I learned how to invest intellectually and for a reason. The goal of investments is so make money and gain capital. On the other hand, there are a lot of risks that take part as well. We started using fundamental analysis at first to determine which stock, bonds, and mutual funds to purchase. Fundamental analysis gives us insight on a company’s revenues, earnings, future growth, return on equity, profit margins and other data to determine a company's underlying value and potential for future growth. In terms of stocks, fundamental analysis focuses on the financial statements of the company being evaluated meaning P/E, Market Caps, and PEG Ratios are considered and calculated. We also took into consideration of the risks imposed when investing.
To reduce a firm’s specific risk or residual risk a portfolio should have negative covariance or rather it should have no variance at all, for large portfolios however calculating variance requires greater and sophisticated computing power. As such, Index models greatly decrease the computations needed to calculate the optimum portfolio. The use of such Index models also eliminates illogical or rather absurd results. The Single Index model (SIM) and the Capital Asset Pricing Model (CAPM) are such models used to calculate the optimum portfolio.
As indicated by the case study S&P 500 index was use as a measure of the total return for the stock market. Our standard deviation of the total return was used as a one measure of the risk of an individual stock. Also betas for individual stocks are determined by simple linear regression. The variables were: total return for the stock as the dependent variable and independent variable is the total return for the stock. Since the descriptive statistics were a lot, only the necessary data was selected (below table.)
So the investor will invest 81.76160279% of the investment budget in the risky asset and 18.23839721% in the
The variance of a portfolio's return is a function of the variance of the component assets as well as the covariance between each of them. Covariance is a measure of the degree to which returns on two risky assets move in tandem. A positive covariance means that asset returns move together. A negative covariance means returns move inversely. Covariance is closely related to "correlation," wherein the difference between the two is that the latter factors in the standard deviation.
The propriety models underpinning our Optimal Market Portfolio incorporate more than 40 global asset classes and 200 asset sectors, resulting in a portfolio diversified based on sources of risk and return. Ongoing multi-factor risk analysis is performed on the portfolio to help minimize overexposure to any specific risk, such as U.S. equity risk or interest rate risk. Our research suggests that properly diversifying a portfolio’s sources of risk and return and not simply adjusting an allocation between stocks and bonds is the key to long term portfolio outperformance.
The systematic risk of a portfolio is the weighted sum of the systematic risk of each component. One can only obtain low systematic risk by choosing securities with low systematic risk for your portfolio. Unsystematic risk is the variation in the stock’s return that cannot be explained by the variation in the market index. For very large portfolios unsystematic risk can be almost eliminated. In this situation the risk each security contributes to the portfolio is approximately equal to its systematic risk or Beta. Therefore, the relevant risk for an individual security held within a well-diversified portfolio is its Beta. Portfolio is the relevant risk is the standard deviation. For example an investor invested all his money in a company’s stock. Then the relevant risk is the standard deviation because the portfolio consists of a single security. On the other hand, the investors holding of the company is a small fraction of a large diversified portfolio. Then the relevant risk is the Beta (Pierre, Gabriel and Albert, 1987).
With the development of capital market, an increasing number of investors have a chance invest their money in the stock exchange. Investment return is the reason that the investors put their money in the stock market. However, when they spend their money in the market, they will come across the risk of the securities. In other words, investors receive the higher investment return which means they will come across the greater risk too. According to Reilly and Brown, risk means the uncertainty of future outcomes. For investors, higher risks might cause their lost more money. The investors have to choose the correct method of their return and risk.
Volatility and uncertainty persists in the financial markets across the world. In this environment, each small and big event affects the markets. Therefore, it