Ch 11/12: Risk and Return Flashcards
What is risk
The reliability of the rate of return
What is financial risk?
The chance that an outcome other than that which was desired will occur
What is uncertainty?
The lack of knowledge of what will happen in the future
Average Annual Return
The arithmetic average of an investment’s realized annual stock returns over a certain period
How do you compute average annual return?
1/TimeInYears(realized return of year one + realized return of year two….)
Average annual return is equal to
realized return
How many years of data do you use to compute average annual return?
The number of years in the future you wish to estimate
Standard deviation tells us what?
How reliable or risky it is
What does a high standard deviation mean?
Has a greater range of possible outcomes, more risky
What does a small standard deviation mean?
More reliable, less uncertainty due to narrower probability distribution
Risk Aversion
Given two securities with equal expected returns but different degrees of risk, the rational investor would choose the one with lower risk
Coefficient of Variation
A way to quantify the relationship between risk and return, shows the risk per unit of return, provides standardized measure of risk
Coefficient of variation is only useful for what?
Stocks in the same industry
How do you find the coefficient of variation?
Standard deviation/return%
When does CV not work?
When stocks are in different industry, or if expected returns are significantly different
Which is less risky: portfolio investing or single security investing?
Portfolio investing
Why is portfolio investing less risky?
The risks of the individual securities comprising the portfolio are averages
Diversification
The tendency for price movements of individual securities to counteract each other
What is the equation to find the expected return of a portfolio?
Sum of [weight (by value) times expected return] for each company
Portfolio Realized Rate of Return
The return that a portfolio actually earned
How do you compute portfolio realized rate of return?
Sum of [weight (by value) times realized return] for each company
Perfectly Positive Correlated Stocks
No diversificatoin
Perfectly Negative Correlated Stocks
Risk is canceled out, ideal diversification
Why is diversification important in investors?
Diversification reduces risk so when you want to pull out your money, there is a higher chance that you will most if not all your money that you invested.
