01-06-2012, 12:46 PM
RISK AND RETURN
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Risk
Risk refers to the possibility that the actual outcome of
an investment will deviate from its expected outcome.
The three major sources of risk are : business risk,
interest rate risk, and market risk.
Modern portfolio theory looks at risk from a different
perspective. It divides total risk as follows.
THE CHOICE BETWEEN A.M. AND G.M.
• A.M … MORE APPROPRIATE MEASURE OF AVERAGE PERFORMANCE OVER SINGLE PERIOD
• G.M IS A BETTER MEASURE OF GROWTH IN WEALTH OVER TIME
CRITIQUE1.
VARIANCE CONSIDERS ALL DEVIATIONS, NEGATIVE AS WELL AS POSITIVE2. WHEN THE PROBABILITY DISTRIBUTION IS NOT SYMMETRICAL AROUND ITS EXPECTED VALUE, VARIANCE ALONE DOES NOT SUFFICE. IN ADDITION, THE SKEWNESS OF THE DISTRIBUTION SHOULD BE CONSIDERED.
DEFENCE1.
IF A VARIABLE IS NORMALLY DISTRIBUTED … AND CAPTURE ALL INFORMATION2. IF UTILITY OF MONEY … QUADRATIC FUNCTION … EXPECTED UTILITY .. f (, )3. STANDARD DEVIATION ANALYTICALLY MORE EASILY TRACTABLE.
SUMMING UP
For earning returns investors have to almost invariably
bear some risk. While investors like returns they abhor
risk. Investment decisions therefore involve a tradeof
between risk and return.