Why, as an investor, do you receive only a 3 percent return on your
deposits in an insured savings account, and at times a double-digit
return on money invested in technology-based mutual funds? How do these
two investments differ other than the returns they provide? The
technology-based mutual fund is much riskier than the insured savings
account. Perhaps the most fundamental relationship in finance is the
tradeoff between risk
and return. On the one hand, if this tradeoff did not exist and the
market viewed all investments as having equal risk, no one would invest
in the low-return insured savings account if they could invest in the
high-return mutual fund. On the other hand, if investors were not
compensated for taking risks, no one would be willing to invest in the
technology-based mutual fund.
As an investor, a financial manager, an entrepreneur, or a person in
any other position that requires making investment decisions, the
relation between risk and return raises three basic questions:
- How do I estimate the percentage return that I will receive on an investment?
- How much risk does an asset add to a portfolio?
- What can I do to eliminate some of that risk?
The expected return
is the market's, or an investor's, best guess as to the return on an
asset. Any technique can be used to arrive at the guess. This section
will review two common techniques. One uses a simple average of
historical returns. Another technique uses the returns from possible
outcomes and the probabilities of those outcomes to arrive at an
Variance and Standard Deviation
Risk is the possibility that actual returns might differ, or vary,
from expected returns. In fact, actual returns will likely differ from
expected returns. It is important for decision-makers to estimate the
magnitude and likelihood of the difference between actual and estimated
returns. After all, there is a big difference if your predictions
result in an error of only $100 versus an error of $1 million.
By using the concepts of variance and standard deviation, investors
can judge not only how wrong their estimates might be, but also
estimate the likelihood, or probability, of favorable or unfavorable
outcomes. With the tools of expected return and standard deviation,
financial decision-makers are better able to evaluate alternative
investments based on risk-return tradeoffs, and their own risk
The Diversification topic answers the third question regarding what
one can do to minimize risk of a group, or portfolio, of investments.
By selecting investments that perform differently under the same market
conditions, one can create a portfolio that has less risk for the same
level of expected return. The concepts of covariance and correlation
are used to measure how the returns on assets relate to each other and
the market in general and how they can be used to reduce the overall
risk to the investor.
Once you answer these basic questions, you may then consider more
advanced question: If it is possible to diversify away some risks by
holding a portfolio of assets, for what risks should investors receive
compensation? Should investors who don't diversify be rewarded with
higher returns? The answers to these questions rest in understanding
different types of risk such as "market" or "non-diversifiable risk"
versus "firm-specific" or "diversifiable" risk. The concept of beta, or
how an asset moves relative to the market, helps investors quantify the
level of diversifiable risk.
Using "Risk and Return" concepts, you should be able to
- compute the expected return of an individual security
- compute the expected return of a portfolio of securities
- compute a confidence interval around an expected return using standard deviation
- compute the variance and standard deviation of an individual security
- compute the variance and standard deviation of a portfolio
- compute beta, a measure of market risk
With a solid understanding of these finance basics, you will be well
prepared to venture into more advanced aspects of financial theory and
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