Flirting with Risk
Lecturer; Murat ERTUĞRUL
4. Demet BARIŞ
FLIRTING WITH RISK
1. Imagine you are Bill. How would you explain to Mary the relationship between risk and return of individual stocks?
As the risk increases the potential return increases as well. In order to get higher returns one needs to invest in riskier assets. In other words, risk is the probability of negative outcome and return is the compensation for this risk.
2. Mary has no idea what beta means and how it is related to the required return of the stocks.
Explain how you would help her understand these topics?
The beta measures the sensitivity of a stock’s price to market movements. Stocks with betas greater than 1, show a more intense version of the market behavior. Stocks with betas between
0 and 1 move in the same direction with the market. Since the market is the portfolio of all the stocks, the average stock has a beta of 1.
3. How should Bill demonstrate the meaning and advantages of diversification to Mary?
A portfolio is simply a combination of investments. If an investor puts half of his funds into an engineering company and half into retail shops firm then it is possible that any misfortunes in the engineering company may be to some extent offset by the performance of the retail investment. It would be unlikely that both would suffer a strike in the same period.
Both the investments would have fluctuating returns over a period of time. They might have the same amount of variability, however, owing purely to the effects of diversification, when engineering performs well retail profits might be down and vice versa.
Diversification into investments with low correlations is always better in case of turbulent times.
The loss incurred on one investment would be offset by profit in others. The correlation