Question

Discuss the concepts of risk and return and diversification. Also, what type of investor would invest in a high beta stock and a low beta stock?

Answer 1

Risk and Return are two concepts which are generally considered together.

Risk: It refers to the possibility that any action or decision taken may go wrong and cause damage or loss.

Return: It refers to the possibility that any action or decision taken may go in our favour and cause profit or gain.

Generally, it isconsidered that " The higher the risk, the higher the return". Portfolio of Investment which has higher risk may alsohave higher return potential.

On the other hand, Diversification may reduce the Risk and Return and bring more stability. It may protect the Portfolio from sudden fall or rise due to bifurcation and variation.

Different Investment Instruments have different Risk and Return Potential. Hence, Diversification into various Investments may prove fruitful in case of higher Volatility.

Beta: It is an indicator that shows the movement potential or volatility of any Investment with relation to its Index. Higher Beta would imply higher volatiliy and hence higher Risk and Return.

An Investor who is Risk Averse would Invest in Instruments which have low Beta, wherease an Investor who is Risk Tolerant would Invest in Instruments which have higher Beta.