Question

Given your risk tolerance, and your need to diversify, explain how the Selected Realized Returns (1926–2013) page 269 and the Effects of Portfolio Risk for Average Stocks will impact your future investment decisions and why

Selected Realized Returns, 1926-2013:

                                        Average Return             Standard Deviation

Small-Company Stocks           16.9%                                32.3%

Large Company stocks             12.1                                    20.2

Long term corporate bonds        6.3                                     8.4

Long-term government bonds     5.9                                     9.8

US Treasury Bills                         3.5                                    3.1

Answer 1

The investment decisions are based on two very important factors:

• 1) The level of risk undertaken
• 2) Your required return from the investmemt

Every individual's level of risk which he can undertake depends upon his risk tolerance. The risk tolerance is further dependent upon many variables:

• Age of the investor: As the investor's age increases, his risk tolerance decreases, as the expected years over which he can recover from the fianancial investment loss decrease. As an individual gets older, his investment horizon decreases and so thus his risk tolerance, espacially if individual is retired he would now have lower risk tolerance and should invest in securities like T-Bills.
• Risk Capital: The net worth and risk capital of an individual also affects his risk tolerance. A risk capital is what the individual can invest that will not affect your lifestyle if lost. A high net worth individual, with high risk capital has a higher risk tolerance and can invest a major portion of his risk capital in stocks like Small-Company stocks and balance the risk by investing in certain long-term lower risk securities like Long term corporate bonds.

An individual's required return from the investmemt also depends upon various factors:

• Creating an income stream: If an investor needs to generate income from his investments, he will most probably invest them in bonds and T-bills as compared to stocks, which promises a fixed income source.
• Capital Preservation: If the objective to invest is just to preserve the invested capital, the investor would demand returns which are atleast equal to the rate of infaltion and lowest possible risk.
• Capital Appreciation i.e. growing the existing capital base. The investor would require a return higher than the long-term inflation rate, at lowest possible risk.