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    Risk and A Single Investment

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    Sheila Mae Guerta Lacerona
    1) The document discusses risk and return within investments, defining risk as the uncertainty of investment outcomes. It analyzes risk through two hypothetical investments: a low-risk treasury bill and a higher-risk stock. 2) Risk is quantified through calculations of standard deviation and diversification is presented as a method to reduce risk. 3) Three sample portfolios diversified across asset classes are shown to demonstrate how diversification can lower risk without reducing returns or raise returns without increasing risk. Diversification is thus presented as a way to improve the risk-return tradeoff of investment portfolios.

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    Risk and A Single Investment

    Uploaded by

    Sheila Mae Guerta Lacerona
    31 views3 pages
    1) The document discusses risk and return within investments, defining risk as the uncertainty of investment outcomes. It analyzes risk through two hypothetical investments: a low-risk treasury bill and a higher-risk stock. 2) Risk is quantified through calculations of standard deviation and diversification is presented as a method to reduce risk. 3) Three sample portfolios diversified across asset classes are shown to demonstrate how diversification can lower risk without reducing returns or raise returns without increasing risk. Diversification is thus presented as a way to improve the risk-return tradeoff of investment portfolios.

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    Risk and a Single Investment

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    Risk and a Single Investment

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    1) The document discusses risk and return within investments, defining risk as the uncertainty of investment outcomes. It analyzes risk through two hypothetical investments: a low-risk treasury bill and a higher-risk stock. 2) Risk is quantified through calculations of standard deviation and diversification is presented as a method to reduce risk. 3) Three sample portfolios diversified across asset classes are shown to demonstrate how diversification can lower risk without reducing returns or raise returns without increasing risk. Diversification is thus presented as a way to improve the risk-return tradeoff of investment portfolios.

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    31 views3 pages

    Risk and A Single Investment

    Uploaded by

    Sheila Mae Guerta Lacerona
    1) The document discusses risk and return within investments, defining risk as the uncertainty of investment outcomes. It analyzes risk through two hypothetical investments: a low-risk treasury bill and a higher-risk stock. 2) Risk is quantified through calculations of standard deviation and diversification is presented as a method to reduce risk. 3) Three sample portfolios diversified across asset classes are shown to demonstrate how diversification can lower risk without reducing returns or raise returns without increasing risk. Diversification is thus presented as a way to improve the risk-return tradeoff of investment portfolios.

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    Risk and a Single Investment

    To help us grasp the fundamental meaning of Risk, consider two possible investments:
    1. The first investment in a U.S treasury bill, which is a government security that
    matures in 90 days and promises to pay an annual return of 6 percent. If we purchase
    and hold this security for 90 days, we are virtually assured of receiving no more and no
    less than 60 percent.
    2. The second investment involves the purchase of the stock of a local publishing
    company. Looking at the past returns of the firms stock, we have made the following
    estimate of the annual returns from the investment:

    Chance ( Probabilty) of Occurence

    Rate of Return on Investment

    1 chance in 10 (10%)
    1 chance in 10 (20%)
    1 chance in 10 (40%)
    1 chance in 10 (20%)
    1 chance in 10 (10%)

    -10%
    5%
    15%
    25%
    40%

    Invest ing in he publishing company could conceivably provide a return as high as 40


    percent if all goes well, or we could lose 10 percent if everything goes against the firm.
    However, in future years, both good and bad, we could expect a 15 percent return on
    average computed as follows.

    K = (.10) (-10%) + (.20) (5%) + (.20)(25%) + (.10)(40%)


    =15%

    Standard Deviation
    A measure of the spread or dispersion about the means of a probability
    distribution. We calculate it by squaring the difference between each squared difference
    by its associated probability, summing over all possible outcomes, and taking the
    square root of this sum.
    k i k

    =
    i=1

    Where n= the number of possible outcomes or different rates of return on their


    investment
    Ki= the value of the with possible return
    K= the expected rate of return
    k

    ( i )= The chance or probability that the ith outcome or return will occur
    P

    For the publishing company, the standard deviation would be 12.85%, determined as
    follows:
    = (-10% - 15%)2 (.10) + (5%-15%)2 (.20)
    + (15% - 15%)2(.40) + (25%-15%)2(.20)
    + (40%-15%)2(.10)
    = 165 =12.85

    Risk and Diversification


    If we diversify our investments across different securities rather than invest to
    only one stock, the variability in the returns of our portfolio should decline. The
    reduction in risk will occur if the stock returns within our portfolio do not move
    precisely together over time- that is, if they are not perfectly correlated. Thus we
    can divide the total risk (total variability) of our portfolio into two types of risk:
    1. Firm-specific risk or company-unique risk
    The portion of the variation in investment returns that can be eliminated through investor
    diversification.
    2. Market related risk
    The portion of variations in investment returns that can be eliminated
    through investor diversification.
    Risk and Diversification Illustration
    To demonstrate the effects of diversification on risks and rates of return,compare three
    portfolios ( A, B,C ) consisting of the following investments:
    Enrollment in local colleges, 2005

    TYPES OF SECURITIES

    Short term government


    securities
    Treasury Bills
    Long Term government
    bonds
    Large company stocks

    INVESTMENTS
    MIX IN
    PORTFOLIO
    A
    B
    C

    0%
    10
    %
    0%
    100

    63%
    12%
    25%
    100
    %

    34%
    14%
    52%
    100
    %

    The results show an investor can use diversification to improve the risk-return
    characteristics of a portfolio. Specifically, we see that:
    1. Portfolio A, which consists entirely of long term government bonds, had an average
    annual return of 5.5% with standard deviation of 11.3%
    2. In portfolio B, we have diversified across all three security types, with the majority of
    the funds (63%) now invested in Treasury Bills and a lesser amount (25%) in stocks.
    The effects are readily apparent the average returns of two portfolios, A and b are
    identical, but the risk has been associated with Portfolio B is almost half that of Portfolio
    A.
    3. Portfolio B demonstrates how an investor can reduced risk while keeping returns
    constant and portfolio C, with its increase investments in stocks (52%), shows how an
    investor can increase average returns while keeping risk constant.

    The market rewards diversification. By diversifying our investments, we can


    indeed lower risk without sacrificing expected return without having to assume more
    risk.

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