Question

Retirement Investment Products (RIP) offers a full complement of retirement planning services and a diverse line of retirement investments that have varying degrees of risk. With the investment products available at RIP, investors could form retirement funds with any level of risk preferred—from risk-free to extremely risky. RIP’s reputation in the investment community is impeccable because the service agents who advise clients are required to fully inform their clients of the risk possibilities that exist for any investment position, whether it is recommended by an agent or requested by a client. Since 1950, RIP has built its investment portfolio of retirement funds to $450 billion, which makes it one of the largest providers of retirement funds in the United States.

You work for RIP as an investment analyst. One of your responsibilities is to help form recommendations for the retirement fund managers to evaluate when making investment decisions. Recently, Howard, a close friend from your college days who now works for SunCoast Investments, a large brokerage firm, called to tell you about a new investment that is expected to earn very high returns during the next few years. The investment is called a “Piggy-back Asset Investment Device,” or PAID for short. Howard told you that he really does not know what this acronym means or how the investment is constructed, but all the reports he has read indicate that PAIDs should be a hot investment in the future, so the returns should be very handsome for those who get in now. The one piece of information he did offer what that a PAID is a rather complex investment that consists of a combination of securities whose values are based on numerous debt instruments issued by government agencies, including the Federal National Mortgage Association, the Federal Home Loan Bank, and so on.

Howard made it clear that he would like you to consider recommending to RIP that PAIDs be purchased through SunCoast Investments. The commissions from such a deal would bail him and his family out of a financial crisis that resulted from “bad luck” they experienced with their investments in the financial markets. Howard has indicated that somehow he would reward you if RIP invests in PAIDs through SunCoast because, in his words, “You would literally be saving my life.” You told Howard you would think about it and call him back.

Further investigation into PAIDs has yielded little additional information beyond what was previously provided by Howard. The new investment is intriguing because its expected return is extremely high compared with similar investments. Earlier this morning, you called Howard to quiz him a little more about the return expectations and to try to get an idea concerning the riskiness of PAIDs. Howard was unable to adequately explain the risk associated with the investment, although he reminded you that the debt of U.S. government agencies is involved. As he says, “How much risk is there with government agencies?”

The PAIDs are very enticing because RIP can attract more clients if it can increase the return offered on its investments. If you recommend the new investment and the higher returns pan out, you will earn a very sizable commission. In addition, you will be helping Howard out of his financial situation because his commissions will be substantial if the PAIDs are purchased through SunCoast Investments.

QUESTION: Should you recommend the PAIDs as an investment? Why?

Keep the following questions in mind as you answer:

• What it means to take risk when investing. How is risk related to 'expected returns?' What does it mean for an investor to be 'risk averse?'

• How would you determine the appropriate return for an investment you chose?

Answer 1

In finance, we define risk as the chance that you will not receive the return that you expect, regardless of whether the actual outcome is better than expected or worse than expected.

Riskier investments, mush have expected returns than less risky investments, otherwise, people will not purchase investments with higher risks.

The total risk of any investment can be divided into two components: diversifiable risk and nondiversifiable risk. Diversifiable risk is not important to informed investors because they will eliminate its effects through diversification. Thus, the relevant risk is nondiversifiable risk because it cannot be eliminated, even in a perfectly diversified portfolio.

The effects of nondiversifiable risk, which is also designated systematic risk or market risk, can be determined by computing the beta coefficient of an investment. The beta coefficient measures the volatility of an investment relative to the volatility of the market, which is considered to be nearly perfectly diversified and thus is affected only by systematic risk.

When the return that investors expect , r^, is lower than the return that they require (demand) for similar risk investments, r, they do not purchase the investment, which causes its price to decline and its expected return to increase until r^=r. When r^>r, investors buy the investment, which increases its price until r^=r.

Risks that are relevant include those types that are related to economic factors, such as interest rate risk, inflation risk, and so forth; risks that are not relevant because they can be diversified away include those types are related to a specific firm or industry, such as business risk, default risk, and so forth.

When investing, first remember, that risk and return are positively related. As a result, in most cases, when you offered an investment that promises to pay a high return, you should conclude that the investment has high risk. When considering possible investments, never seperate "risk" and "return" - that is, do not consider the return of an investment without also considering its risk. Second, remember that, you can reduce some investment risk through diversification, which can be achieved by purchasing different investments that are not hightly positively related to each other. In many instances, you can reduce risk without reducing the expected rate of return associated with your investment position.

Many investors examine the past performance of an investment to determine its expected return. Care must be taken with its approach because past returns often do not reflect future returns. Even so, you might be able to get a rough idea as to what you expect a stock's long-term growth to be in the future by examining its past growth, especially if the firm is fairly stable. Investors also rely on information provided by professional analysts to form opinions about expected rates of return.

To determine an investment's required rate of return, investors often evaluate the performances of similar-risk investments. In addition, some investors use the CAPM to get a "ballpark figure" for an investment's required rate of return. The beta coefficients for most large companies can be obtained from many sources, including the internet; the risk-free rate of return can be estimated using the rates on existing Treasury Securities; and the expected market return can be estimated by evaluating market returns in recent years, the current trend in the market, and predictions made by economists and investment analysts.

When investing your money, keep these words of wisdom in mind: "if you lose sleep over your investments or are some concerned with the performance of your portfolio than with your job performance, then your investment position probably is too risky."