Portfolio risk and return

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Portfolio Risk and Return

Objective:

Constructing an optimal portfolio involves assessing the risk and return of individual assets, understanding their correlations, and selecting the best combination to suit the investor's preferences.

Risk and Return Characteristics

  • Risk:
    Risk is the uncertainty of returns, which can be systematic (market-related) or unsystematic (company-specific).
  • Return:
    Returns are the gains from investments, and higher risk typically corresponds to higher potential returns.

Types of Risks

  • Systematic Risks:
    Market-related risks, including inflation, interest rates, and economic policies, which affect all investments.
  • Unsystematic Risks:
    Company-specific risks that can be mitigated through diversification.

Risk and Correlation

  • Correlation:
    The relationship between the risks of individual assets is crucial. Proper diversification can reduce overall portfolio risk by combining assets with low or negative correlations.
  • Beta:
    A measure of an asset's volatility relative to the market. Combining assets with different betas can help balance portfolio risk.

Risk-Free Return and Risk Premium

  • Risk-Free Return:
    The return on investments with negligible risk, such as government securities.
  • Risk Premium:
    The additional return required to compensate for taking on higher risk.

Tradeoff Between Risk and Return

  • Tradeoff:
    Higher returns require taking on higher risks. Investors need to balance their desire for returns with their risk tolerance.

Portfolio Management

  • Goal:
    Plan investments to ensure a balance between risk and return, considering both systematic and unsystematic risks.
  • Diversification:
    Spreading investments across different assets to mitigate risks.

Decomposition of Return

  • Components of Portfolio Return:
    • Risk-Free Return: The return from low-risk investments.
    • Excess Return: The additional return above the risk-free rate, influenced by the level of risk taken and the investor's expertise.
  • Fama's Decomposition:
    Breaks down returns into risk-free return, excess return, risk premium, selectivity return, and manager's expertise return.

Key Points

  • Risk Management:
    Essential to balance risk and return and construct a diversified portfolio.
  • Investor's Risk Profile:
    Understanding the investor's risk tolerance is crucial for optimal portfolio selection.
  • Diversification:
    Reducing risk by spreading investments across different assets.

Conclusion:

Effective portfolio management involves understanding risk and return, diversifying investments, and selecting the optimal portfolio based on the investor's risk tolerance and return expectations. This approach aims to maximize returns while minimizing risks, ensuring a well-rounded investment strategy.