Chapter 8

Investment risk

quantifiable uncertainty about gains and losses

Two types of investment risk

stand-alone & portfolio

Stand-alone risk

risk an investor would face if they held only one asset

Bernie Madoff takeaways

fabricated investment activity & failed regulatory oversight; 2008 Financial crises exposed scheme

Portfolio

collection of assets; objective is diversification of risks

Risk-return trade-off for a portfolio is measured by

portfolio is expected return and portfolio standard deviation

Portfolio weight

percentage of a portfolio’s total value that is invested in a particular asset

Unsystematic/diversifiable risk

factors that affect a single asset or limited number of assets

Systematic/non-diversifiable risk

factors that affect the whole market or a large number of assets; measured with beta

Beta greater than one

more volatile

Capital asset pricing model

model linking risk and required returns

What does beta tell us?

stock’s sensitivity to the market portfolio

Principle of Diversification

reduction in risk arises because worse than expected returns from one asset are offset by better-than-expected returns from another

Diversification

investment in several different asset classes or sectors

What’s included in expected return on a portfolio

performance of each security given economic states, projected states of economy/probability of each occurrence, and percentage of the portfolio invested in each individual security

States of economy

recession, normal, and boom