Systematic risk and specific risk[ edit ] Specific risk is the risk associated with individual assets - within a portfolio these risks can be reduced through diversification specific risks "cancel out".

Variance of Returns of Individual Investment Variance of an individual investment simply equals squared standard deviation. It is important to analyze and attempt to quantity the relationship between risk and return.

Standard Deviation of Returns of Individual Investment Historical standard deviation of an investment on a standalone basis can be estimated by calculating its standard deviation using the following general formula: Time also plays an essential role in determining a portfolio with the appropriate levels of risk and reward.

ERSD and Variance of a Portfolio Portfolio Expected Return Expected return of a portfolio is calculated as the weighted average of the expected return on individual investments using the following formula: The fact that all points on the linear efficient locus can be achieved by a combination of holdings of the risk-free asset and the tangency portfolio is known as the one mutual fund theorem[3] where the mutual fund referred to is the tangency portfolio.

Likewise, given a desired level of expected return, an investor can construct a portfolio with the lowest possible risk. Portfolio Risk and Expected Return MPT makes the assumption that investors are risk-averse, meaning they prefer a less risky portfolio to a riskier one for a given level of return.

By adding more and more investments to a portfolio, unsystematic risk can be eliminated, hence, it is also called diversifiable risk. Risk in equity investments is broadly classified into unique risk also called unsystematic risk and systematic risk.

Thus relative supplies will equal relative demands. The CAPM is usually expressed: This plot reveals the most desirable portfolios. ERSD and Variance of Individual Assets Expected Return of Individual Investment Expected return of an individual investment can be estimated by creating a distribution of likely return and their associated likelihood using the following formula: Modern portfolio theory and capital asset pricing model offer a framework for analysis of risk-return tradeoff.

For example, assume Portfolio A has an expected return of 8.

Market neutral portfolios, therefore will have a correlations of zero. Its component risks are interest rate risk, inflation risk, regulatory risk, exchange rate risk, etc.

For example, a penny stock position may have a high risk on a singular basis, but if it is the only position of its kind in a larger portfolio, the risk incurred by holding the stock is minimal.

Asset pricing[ edit ] The above analysis describes optimal behavior of an individual investor. Measuring Singular Risk in Context and Portfolio Risk Level When an investor considers high-risk-high-return investments, the investor can apply the risk-return tradeoff to the vehicle on a singular basis as well as within the context of the portfolio as a whole.

This implies than an investor will take on more risk only if he or she is expecting more reward. Investors use the risk-return tradeoff as one of the essential components of each investment decision, as well as to assess their portfolios as a whole. For investors, assessing the cumulative risk-return tradeoff of all positions can provide insight on whether a portfolio assumes enough risk to achieve long-term return objectives or if the risk levels are too high with the existing mix of holdings.

The percentage return on an individual investment can be calculating using the following holding period return formula: If two and more assets have correlation of less than 1, the portfolio standard deviation is lower than the weighted average standard deviation of the individual investments.Modern portfolio theory (MPT) looks at how risk-averse investors can build portfolios to maximize expected return based on a given level of market risk.

AN INTRODUCTION TO RISK AND RETURN CONCEPTS AND EVIDENCE by Franco Modigliani and Gerald A. Pogue1 Today, most students of financial management would agree that the treatment of risk is the main element in financial decision making.

Portfolio theory deals with the measurement of risk, and the relationship between risk and return. Risk-return tradeoff is a specific trading principle related to the inverse relationship between investment risk and investment return.

The "Efficient Frontier" is a modern portfolio theory.

RISK & RETURN 10/12/12 The concept and measurement of Return: Realized and Expected return. • Portfolio risk, or systematic risk), is the risk one still bears after achieving full diversification (cov).

• Diversifiable, or unsystematic risk, is the risk that can be. An efficient portfolio is one that offers: the most return for a given amount of risk or the least risk for a given amount of return.

An investor's optimal portfolio is defined by the tangency point between the efficient set and the investor's.

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