Risk and Rates of Return

Risk Aversion

Investors dislike risk and require higher rates of return as an inducement to buy riskier securities.

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No investment should be undertaken unless the expected rate of return is high enough to compensate for the perceived risk.

Standard Deviation σ

Quantifies the tightness of the probability distribution; a measure of how far the actual return is likely to deviate from the expected return.

Correlation

Tendency of two variables to move together.

Diversifiable Risk

That part of a security's risk associated with random events; it can be eliminated by proper diversification. This risk is also known as company-specific, or unsystematic risk.

Risk

The chance that some unfavorable event will occur.

Risk Premium

The difference between the expected rate of return on a given risky asset and that on a less risky asset.

Expected Rate of Return, r^

The rate of return to be realized from an investment; the weighed average of the probability distribution of possible results.

Stand-Alone Risk

The risk an investor would face if he or she held only one asset.

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The risk of a stock held in a portfolio is typically lower than the stock's risk when it is held alone.

Market Risk

The risk that remains in a portfolio after diversification has eliminated all company-specific risk. Also known as beta risk.

Coefficient of Variation

The standardized measure of the risk per unit of return; calculated as the standard deviation divided by the expected return.

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The tighter the probability distribution, the lower the risk.

Expected Return on a Portfolio

The weighted average of the expected returns on the assets held in the portfolio.

Trade-off Between Risk and Return

To entice investors to take on more risk, you have to provide them with higher expected returns.

Average Stock's Beta

bA=1.0 because an average risk stock is one that tends to move up by 10% when the market moves up by 10% and fall by 10% when the market falls by 10%.

Expected Rate of Return

r^= P1r1 + P2r2... Pnrn

S&P 500

An index of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. Designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe.

Mutual Funds

An investment vehicle that is made up of a pool of funds collected from many investors for the purpose of investing in securities. Operated by money managers, who invest the fund's capital and attempt to produce capital gains and income for the fund's investors.

Beta Coefficient

A metric that shows the extent to which a given stock's returns move up and down with the stock market. It measures market risk.

Market Portfolio

A portfolio consisting of all stocks.

Probability Distribution

A listing of possible outcomes or events with a probability (chance of occurrence) assigned to each outcome.

Correlation Coefficient

A measure of the degree of relationship between two variables.