Discuss investor’s required rate of return, and how the riskiness of an asset is measured and interpreted. Assess how diversifying investments would affect the riskiness and expected rate of return of a portfolio or combination of assets. Discuss unsystematic risk, systematic risk, characteristic line, beta, portfolio beta, and asset allocation.
An investor’s rate of return is the amount of money an investment gains or loses over a period of time. This is the back bone when it comes to investing. There are a lot of factors that go into measuring and interpreting the amount of risk involved in an investment. Diversifying investments is a good way to reduce the amount of risk involved in a portfolio. Spreading out your investment across different markets such as buying stocks in the oil, technology, and health care sectors helps reduce risk. Compared to investing only in one sector such as oil, if the price of oil were to drop, your portfolio won’t be crushed because you still have large investments in other sectors such as health care and technology.
Asset allocation is the strategy an investor takes towards their investments. A lot of factors go into asset allocation. Some of the factors include the amount of time available to invest. For example, an 30 year old would be able to tolerate more risk than a 60 year old because the 30 year old has much more time to recover incase the riskier investment ends up being a loss. Goals are also a huge factor in asset allocation. If someone needs $10 million to retire while someone else only needs $500,000, their investment goals will be much different.
Systematic risk is the amount of risk involved across an entire market. This includes the amount of risk involved in markets such as the stock market, bonds, or real estate. Unsystematic is the amount of risk involved with sectors. For the stock market this could be the sectors mentioned before, health care, technology, or oil. For real estate this could be residential housing, office leasing, or retail outlets.
A characteristic line is similar to a line of regression. This is a line on a graph of time and value of an investment. It averages the value of an investment over periods of time to show where the investment is going in value in the future.
Beta is used to show the level of risk involved with an investment. If an investment has a beta of less than 1.0 it is less volatile than the market. If an investment has a beta of 1.12 this means that it is 12 percent more volatile than the market. Portfolio beta is gauges how volatile a portfolio is based on beta. It is calculated by taking the the averages of beta of all the investments in a portfolio.