Return, Risk and The Security Market Line - An Introduction to Risk and Return

Whether it is investing, driving or just walking down the street, everyone exposes themselves to risk. Your personality and lifestyle play a big role in how much risk you are comfortably able to take on. If you invest in stocks and have trouble sleeping at night, you are probably taking on too much risk. (For more insight, see A Guide to Portfolio Construction.) Risk is defined as the chance that an investment's actual return will be different than expected. This includes the possibility of losing some or all of the original investment.

Those of us who work hard for every penny we earn have a hard time parting with money. Therefore, people with less
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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.

Modern portfolio theory says that portfolio variance can be reduced by choosing asset classes with a low or negative covariance, such as stocks and bonds. This type of diversification is used to reduce risk.

Portfolio variance looks at the covariance or correlation coefficient for the securities in the portfolio. Portfolio

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