Question

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. The required rate of return is rate decided by investor basis her risk appetite, the rate changes from investor to investor and instruments to instruments. For Example, an investor considers investing in a start-up which is high risky may set a required rate of return as 35% to 50%, whereas another investor investing in a risk-free investment such as t-bills may set a required return as 1% to 2%.

The expected rate of return uses probabilities to weigh the various return outcomes that an investment may produce. If the probabilities uses are same, the investment will provide the same expected rate of return irrespective of the investor.

If the expected rate of return is more than the required rate of return then the investment should be considered.

2. A holding period return is the realized returns from holding an investment for a specified period. A holding period return is a return after investing into an asset or instrument whereas the expected rate of return is an estimated rate of return.

3. Diversification reduces the unsystematic risk since the risk of return from one investment will counterbalance the risk from other investments in the same portfolio. However, diversification won't be effective in reducing the risk if the risk is a systematic ie risk which will affect the entire market.