Question

This week, let's talk about investments andinvestment risk. In class with you today are individuals with various experience in investing - some may be seasoned professionals, while others may have very little experience. Either case is perfect okay because we all approach investing, risk, and return differently.

When you invest your money, you have to consider a basic risk-return tradeoff. The risk-return tradeoff is the balance between the desire for the lowest possible risk and the highest possible returns. In general, low levels of uncertainty (low risk) are associated with low potential returns and high levels of uncertainty (high risk) are associated with high potential returns (link).

1. Describe three factors that influence your evaluation of the risk of an investment
2. What factors influence risk tolerance?
3. How does diversification positively and negatively affect risk?
4. What type of investor would invest in a high beta stock and a low beta stock?

Answer 1

Three factors that influence my evaluation of risk of an investment are: (i): Investment time frame – Investments can be made for short term or for long term. For short term investments my evaluation of risk tends to be more specific and I adopt a conservative investment approach. However in case of long term investments my evaluation is more systematic and I adopt a more aggressive approach towards investing. (ii): My investment objectives – My evaluation of risk for an investment is also influenced by my investment objectives. When I invest money for the purpose of capital appreciation my evaluation of risk is influenced by the current market conditions and I invest in equities and mutual funds. On the other hand investments for specific purposes like marriage and buying a house entails evaluation of risk using a conservative approach. (iii): My risk capital – Risk capital (also known as liquid capital) is that amount of money that is available to invest or trade and whose investment will not affect my lifestyle even if the entire amount of capital is lost. When risk capital is a small percentage of my overall net worth then evaluation of risk is more end result oriented and not too much consideration is given to the quantum of risk being taken.

The primary factors that influence risk tolerance are age of the investors, investment experience of the investor, future earning capacity of the investor and other factors like inheritance. Generally young investors have higher levels of risk tolerance than investors who are old. Individuals who have rich investment experience will have higher levels of risk tolerance than individuals who have no experience or have very little investment experience. Lastly for individuals who have high future earning capacity the risk tolerance level will be quite high.

The positive impact of diversification is that it reduces the overall risk level. Diversification leads to leveling out of volatility and risk. If investments are spread across different industries and companies and asset class then even if one asset class falls the portfolio will not be fully negatively impacted. The negative impact of diversification is that it can affect the absolute risk amount as certain transaction costs are associated with diversification. Also risk is, in some cases, increased when a portfolio is widely diversified and investors diversify without much knowledge of the industries or asset class in which they are investing.

The investor with high risk tolerance will invest in a high beta stock while an investor with low risk tolerance will invest in a low beta stock. This is because high beta stocks are more volatile in nature while low beta stocks have lower levels of volatility and risks associated with them.