portfolio is a collection of assets An asset’s risk and return is important as it affects the risk and return of the portfolio
diversification is the investment in several different asset classes or sectors Diversification is not just holding a lot of assets For example, if you own 50 internet stocks, you are not diversified t di ifi d However, if you own 50 stocks that span 20 different industries, and 10 countries, then you are more diversified
Types of “Risk” Risk
Systematic Risk Unsystematic Risk
factors that affects every business or every
asset Also known as non-diversifiable risk or market risk I l d Includes such things as changes in GDP, h thi h i GDP inflation, interest rates, etc.
Unsystematic or Idiosyncratic Risk
factors that affect a limited number of assets or a specific industry/company Also known as unique risk and asset-specific risk I l d Includes such things as l b strikes, part h thi labor t ik t shortages, senior management departures, etc.
risk that can be eliminated by combining assets into a portfolio Often considered the same as unsystematic, unsystematic unique or asset-specific risk
Return = Risk free return + systematic portion + unsystematic portion
Measuring Systematic Risk
do we measure systematic risk? y We use the beta coefficient to measure y systematic risk What does beta tell us? A beta of 1 implies the asset has the same systematic p y risk as the overall market A beta < 1 implies the asset has less systematic risk than the overall market A beta > 1 implies the asset has more systematic risk than the overall market
Beta and the Risk Premium
that the risk premium = expected return – risk-free rate The higher the beta the greater the risk...