Question

1. Explain the difference between required rate of return and expected rate of return. If they are different at a specific point in time, what does it mean?

2. What is the difference between an expected return and a total holding period return?

3. How does investing in more than one asset reduce risk through diversification?

Answer 1

1. Required rate of return is the return based on the market risk, risk free rate and risk of investing in the security. It is same regardless the economic situation of the country.

An expected return is the average probabilistic return based on the different economic situation for a particular security.

Required rate of return and expected rate of return is different when economic situation is other than normal. If they are not same, it means economic situation is more than normal (boom) or less than normal (recession).

2. An expected return is the average probabilistic return based on the different economic situation for a particular security whereas a total holding period return is the total return (including capital gain and dividend/interest income) for a particular period.

3. Investing in more than security reduces risk.

Say, Standard deviation of stock A is 50%, and stock B is also 50% but their correlation coefficient is 0.5. If they have same weight i.e. 50% in a portfolio.

Then standard deviation of the portfolio= SQrt of (0.5^2*50%^2+0.5^2*50%^2+2*0.5*0.5*50%*50%*0.5)=43.33%

Hence, even if they have same standard deviation or volatility for both the stocks, their portfolio has lesser volatility than individual stocks.

Theoritically, the probability one of the stock going down or up is more than the probability of both the stock simultaneously going down or up. Hence, portfolio of more than one asset always reduce risk by diversification.