Question

What is the significance of “risk premium” to investors in selecting their investment portfolios and how does asset diversification affect market risk in an asset portfolio?

Explain each with examples.

Answer 1

Significance of Risk Premium to investors in Portfolio Selection and how asset diversification can affect the market risk can be explained as below: (Examples are inside the explanation part)

First of all, what is a Risk Premium?... Every asset/equity will have it's own risk and we figure out the risk premium by subtracting risk free rate of return from the expected return. Why is it Significant? It is significant in order to weigh the stock or an asset as more risky,considerably risky,risky, less risky, lower risky etc. This plays a crucial role while calculating Capital Asset Pricing Model which explains the connection in between the risky equity and systematic risk.

There are many different types of investors with different expectations, with different risk appetites, holding different strategy of winning and losing the bets over the Stock Exchange. Let's say for an example, if you'd consider a person who'd want to retire early and wants to invest in a stock which will give an yield in his old age, he may have preferences of lower risk appetite, long time horizon , more withdrawal requirements in the old age etc. Here the risk premium is considered as the the person wants to use the funds after his retirement and has a lower risk appetite.

Now to understand the asset diversification, we need to understand the term itself. Asset diversification happens when you'd prefer to maintain a stock portfolio of different companies from different industries with different risk-return strategies. For example, if you'd want to purchase a tobacco firm's stock which is giving higher return over higher risk, you'd consider another firm which is into FMCG and is giving medium return over low-medium risk. This balances off the loss made by one stock with the gain made by another stock. Putting all eggs in one basket can risk the whole eggs in an accident. That's how we conclude that by diversifying the portfolio of stocks we'd eradicate the market risk.