15.2 Risk and Return to Multiple Assets
3 min read•june 18, 2024
is key to managing . By spreading investments across various assets, investors can reduce overall risk while maintaining potential returns. This strategy capitalizes on the imperfect between different assets, allowing for a more balanced performance.
The risk-return tradeoff is central to portfolio management. Investors aim to find the sweet spot on the , balancing their desired returns with an acceptable level of risk. This approach helps investors make informed decisions based on their individual and financial goals.
Portfolio Risk and Return
Diversification for risk reduction
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- spreads investments across multiple assets with different risk and return characteristics (stocks, bonds, real estate)
- Reduces overall portfolio risk by offsetting potential losses in some assets with gains in others
- Assets with low or negative correlation (gold and stocks) help balance portfolio performance
- Portfolio risk is lower than the weighted average risk of individual assets held
- Imperfect correlation between asset returns (international and domestic stocks) leads to risk reduction
- Combining assets with different risk profiles (Treasury bonds and small-cap stocks) minimizes portfolio volatility
- determines the mix of different asset classes in a portfolio to achieve desired risk-return characteristics
Risk-return tradeoff in portfolios
- Investors aim to maximize return for a given risk level or minimize risk for a target return
- Efficient frontier represents optimal portfolios with the highest expected return at each risk level
- Portfolios below the efficient frontier are suboptimal, as they have lower returns for the same risk
- Investors select a portfolio on the efficient frontier based on their risk tolerance
- Risk-averse investors choose lower-risk portfolios (more bonds) with lower expected returns
- Risk-seeking investors prefer higher-risk portfolios (more stocks) with higher expected returns
- measures portfolio performance considering the level of risk taken ()
Firm-specific vs systematic risk
- () is unique to a specific company or industry
- Management changes (CEO resignation), labor strikes, or product recalls (faulty airbags)
- Can be reduced through diversification by investing in multiple companies and industries
- () impacts the entire market or economy
- Interest rate changes, inflation, or political events (elections)
- Cannot be eliminated through diversification, as it affects all assets in the market
- Well-diversified portfolios are mainly exposed to , as is largely diversified away
- measures an asset's sensitivity to systematic risk relative to the market
Portfolio size and risk impact
- As the number of assets in a portfolio grows, the impact of firm-specific risk decreases
- Diversification benefits are greatest when adding the first few assets to a portfolio
- Marginal risk reduction diminishes with each additional asset
- Portfolio risk approaches the level of systematic risk as the number of assets increases
- A well-diversified portfolio with many assets has minimal exposure to firm-specific risk
- The risk of a well-diversified portfolio is primarily driven by systematic factors
- Investors can achieve sufficient diversification with a relatively small number of well-selected assets
- Owning too many assets can increase transaction costs and management complexity (tracking 100+ stocks)
Modern Portfolio Theory and Risk Management
- provides a framework for constructing optimal portfolios based on expected returns and risk
- measures how two assets move together, helping investors understand diversification benefits
- represents the set of optimal portfolios combining the risk-free asset and the market portfolio
Key Terms to Review (23)
Asset Allocation: Asset allocation is the process of dividing an investment portfolio among different asset classes, such as stocks, bonds, and cash, in order to manage risk and optimize returns. It is a fundamental concept in finance that helps investors achieve their financial goals by balancing the risks and rewards associated with different investment options.
Beta Coefficient: The beta coefficient, or simply beta, is a measure of the volatility or systematic risk of an individual asset or security in relation to the overall market. It quantifies the sensitivity of an asset's returns to changes in the broader market's returns.
Capital Market Line: The capital market line (CML) is a graphical representation of the relationship between the expected return and risk (as measured by standard deviation) of a portfolio of assets in an efficient market. It depicts the optimal allocation of risky and risk-free assets to achieve the highest possible return for a given level of risk.
Correlation: Correlation is a statistical measure that describes the strength and direction of the linear relationship between two variables. It quantifies how changes in one variable are associated with changes in another variable.
Covariance: Covariance is a statistical measure that indicates the degree to which two random variables move in relation to each other. It quantifies the strength and direction of the linear relationship between two variables, providing insight into their joint behavior.
COVID-19: COVID-19 is a global pandemic caused by the novel coronavirus SARS-CoV-2, significantly impacting economic activities and financial markets. It has led to disruptions in supply chains, market volatility, and changes in consumer behavior, affecting corporate financial health and investment decisions.
Diversification: Diversification involves spreading investments across various financial assets to reduce risk. It aims to minimize the impact of any single asset's poor performance on an overall investment portfolio.
Diversification: Diversification is the practice of investing in a variety of assets to reduce the overall risk of a portfolio. It involves spreading investments across different asset classes, industries, and geographic regions to minimize the impact of any single investment's performance on the overall portfolio.
Efficient Frontier: The efficient frontier is a concept in finance that represents the set of optimal portfolios, where each portfolio offers the maximum expected return for a given level of risk or the minimum risk for a given level of expected return. It is a crucial tool for understanding and optimizing the risk-return tradeoff in investment decisions.
Fidelity Investments Inc.: Fidelity Investments Inc. is a multinational financial services corporation that offers investment management, retirement planning, portfolio guidance, brokerage services, and a wide range of mutual funds. It is known for its robust research capabilities and comprehensive financial tools for individual and institutional investors.
Firm-specific risk: Firm-specific risk is the risk associated with an individual company or asset, independent of market-wide factors. It can be mitigated through diversification in a portfolio.
Firm-Specific Risk: Firm-specific risk, also known as unsystematic risk, refers to the risk associated with a particular company or asset that is independent of overall market or industry performance. It is the risk that is unique to a specific firm and can be diversified away by investing in a portfolio of assets.
Market Risk: Market risk, also known as systematic risk, is the risk associated with the overall fluctuations in the financial markets. It is the uncertainty inherent in the performance of the market as a whole, which can impact the value of an investment or a portfolio of investments. Market risk arises from factors such as changes in interest rates, economic conditions, political events, and other macroeconomic factors that affect the entire market.
Portfolio: A portfolio is a collection of financial assets such as stocks, bonds, and cash equivalents held by an investor. It is designed to achieve specific investment goals while managing risk through diversification.
Portfolio Risk: Portfolio risk refers to the overall level of uncertainty or volatility associated with the performance of a collection of investments, known as a portfolio. It is a measure of the potential for the portfolio's value to fluctuate over time, reflecting the combined risks of the individual assets within the portfolio.
Portfolio Theory: Portfolio theory is a framework for analyzing the selection and management of a collection of investment assets, with the goal of maximizing expected return for a given level of risk. It provides a systematic approach to constructing and evaluating investment portfolios by considering the relationships and tradeoffs between risk and return.
Risk Tolerance: Risk tolerance is an individual's willingness and ability to accept the possibility of financial loss or other negative outcomes in pursuit of potential gains. It is a crucial concept in the context of investment decisions and risk management strategies.
Risk-adjusted return: Risk-adjusted return is a measure of the return on an investment or portfolio, adjusted for the amount of risk taken to achieve that return. It allows for a more meaningful comparison of investments with different risk profiles by accounting for the level of risk inherent in each investment.
Sharpe ratio: The Sharpe ratio measures the performance of an investment compared to a risk-free asset, after adjusting for its risk. It is calculated by subtracting the risk-free rate from the investment return and then dividing the result by the standard deviation of the investment's excess return.
Sharpe Ratio: The Sharpe ratio is a measure of the risk-adjusted return of an investment or portfolio. It is calculated by dividing the average return of an investment by its standard deviation, providing a metric to evaluate the performance of an asset relative to the risk taken.
Systematic risk: Systematic risk is the risk inherent to the entire market or a market segment. It cannot be eliminated through diversification and is influenced by factors such as economic changes, political events, and natural disasters.
Systematic Risk: Systematic risk, also known as market risk or undiversifiable risk, is the risk inherent to the entire market or market segment, which cannot be mitigated through diversification. It is the risk that affects all assets and cannot be eliminated by holding a diversified portfolio.
Unsystematic Risk: Unsystematic risk, also known as diversifiable or idiosyncratic risk, refers to the risk that is specific to an individual asset or a small group of assets. It is the portion of an asset's total risk that is not related to overall market movements or systematic factors, and can be reduced or eliminated through diversification.