Question

6. In two paragraphs, describe the concept of “return versus risk,” and explain how you would use it in selecting a new investment portfolio. Explain how and why you used (or did not use) this concept when you chose your original two stocks. In your explanation, ensure that you answer the following questions: a. What would you do differently if you were to choose another two stocks for your portfolio? Explain your answer. b. What specific actions could you take in the future when choosing stock investments to reduce risk and increase the reward in your portfolio?

Answer 1

Return is the periodic cash flows earned from stock (e.g. dividends from stock) together with appreciation in the price of the asset (capital gain). An investor cannot be sure of the amount of return as there can be many possibilities. Expected return is the weighted average of possible returns, with the weights being the probabilities of occurrence. Risk is the variability between the expected and actual returns. Systematic risk affects the overall market, such as change in the country's economic position, tax reforms or change in the world energy situation. Unsystematic risk is associated with a company or industry.

While selecting the stocks in my portfolio, I specifically selected stocks of different industries to diversify my portfolio. Being a risk averse investor, I chose stocks which had reached the peak in their life cycle and were giving stable returns. Stocks which are in their growth stage give aggressive returns as they make aggressive investments to penetrate the market.

a. Sensitivity analysis can be done between various stocks to assess the risk. One of the ways is finding out the range of the asset (Maximum Value - Minimum Value). Higher the range of the stock, higher the risk.

Standard deviation is another tool for assessing risk associated with a particular investment. Standard deviation measures the variability around expected value. If two stocks have the same expected return but different standard deviation, then the stock having lower standard deviation is preferred as the one having higher standard deviation is prone to higher fluctuations.

b. Picking stocks which are not positively correlated is one of the ways to reduce risk and increase reward. Choosing stocks from different sectors/industries (diversification) can be used as a tool to reduce the unsystematic risk and increase return. The portfolio should contain some high risk and some low risk stocks.