Question

1. In finance terms, what is risk? How does risk impact investor behavior and shape the expected return an investor might have for a particular security?
2. How does diversification help deal with risk? Be specific in discussing the benefits of diversification.

Answer 1

Risk is defined in terms of variability in expected returns.

It arises because the returns are not certain or fixed or cannot be predicted in advance. It must be noted that all the investments are subject to risk, however the level of risk differs from security to security.

Return may be defined as total income generated by investment.

There is a positive correlation between risk and return. Greater the risk, more the returns.

Some investments are riskier than others – there’s a greater chance you could lose some or all of your money. Stocks have a potentially higher return than bonds over the long term, but they are also riskier. Bond investors are creditors. As a bond investor, you’re legally entitled to fixed amounts of interest and principal and are repaid in priority if the company goes bankrupt.

Government securities are safest securities, hence the returns are less. Returns on risk free asset is actually a compensation for time or simply time value of money. There is no compensation for underlying risk. The additional return over and above risk free return is compensation for underlying risk. This is called risk premium.

Risk is caused by host of external and internal factors. The total risk of an investment can be broken down into-

--> Unsystematic or diversifiable or company-specific risk, and

--> Systematic or non-diversifiable risk or beta or market risk.

You can avoid unsystematic risk by diversification. You cannot avoid systematic risk.

All rational investors like returns but at the same time dislike risk. hence, all investors are risk averse. They want higher returns for every additional unit of risk. To avoid this risk Securities Portfolio/ Diversification concept comes into picture.

In order to avoid risk, some investors invest in a large number of securities. The basic idea here is DONOT PUT ALL YOUR EGGS IN ONE BASKET. This will lead to risk reduction.

With diversification, total risk can be reduced as if there is change in one company's internal governance or management, there will not be chances that the investor will loose all his money. He will not be subjected to only one company's risk.

With help of diversification, more returns can be earned by taking same level of risk or same returns can be earned with less risk involved. Hence, diversification helps in risk reduction.

Hope it helps!