Risk and Return
Risk and return in investing are highly interrelated. Increasing potential investment gains are typically accompanied by increased risk. Different sorts of hazards include project-specific, industry-specific, competitive, international, and market risks. “Return refers to the profits or losses generated through trading a security.
The return on an investment is expressed as a percentage and is regarded as a random variable that can take on any value within a certain range. Several factors affect the type of profits that investors can anticipate from market trading.
Diversification allows investors to lower the portfolio’s overall risk, but it may limit possible gains. Investing in a single market sector may provide greater returns if that sector dramatically outperforms the broader market, but if that sector underperforms, you may suffer fewer returns than you would have with a diversified portfolio.
How Diversification Reduces or Eliminates Firm-Specific Risk
First, each investment in a diversified portfolio represents a negligible proportion of the portfolio as a whole. So, any risk that raises or lowers the value of that specific investment or set of investments won’t have much of an effect on the portfolio as a whole.
Second, the effects of firm-specific activities on the prices of individual assets within a portfolio might be either positive or negative for each asset over any given period. So, it makes sense to think that in large portfolios, positive and negative effects will average out so that they don’t change the overall risk level of the portfolio.
Furthermore, the benefits of diversification can be demonstrated mathematically.
σ^2portfolio= WA^2σA^2 + WB^2σB^2 + 2WA WBр ABσ AσB
Where:
- σ = standard deviation
- W = weight of the investment
- A = asset A
- B = asset B
- р = covariance
With all else being equal, the greater the correlation between the returns of two assets, the lesser the potential benefits of diversification.
Analysis of Risk and Return Models in Comparison
- Model of Capital Asset Pricing (CAPM)
- APM Multifactor model
- Proxy models
- Financial and debt-based accounting models
For investments with equity risk, the best way to quantify risk is to examine the deviation of actual returns from the projected return. In the CAPM, market beta is used to quantify exposure to market risk. The APM and the multifactor model permit the examination of numerous sources of market risk and the estimation of betas for an investment with respect to each source. A regression or proxy model for risk employs firm characteristics, such as size, that have historically been connected with strong returns to estimate market risk.
On investments with default risk, the level of risk is determined by the possibility that the promised cash flows will not be provided. A default premium is the premium we demand above a risk-free rate for investments with a greater risk of default. Even without ratings, interest rates will include a default premium that reflects lenders’ default risk estimations. These default-risk-adjusted interest rates measure the cost of debt or borrowing for a company.
References : Corporate finance institute | Wikipedia
