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In investing, risk and return are highly correlated. Increased potential returns on investment usually go hand-in-hand with increased risk. Different types of risks include project-specific risk, industry-specific risk, competitive risk, international risk, and market risk. Return refers to either gains or losses made from trading a security.
The return on an investment is expressed as a percentage and considered a random variable that takes any value within a given range. Several factors influence the type of returns that investors can expect from trading in the markets.
Diversification allows investors to reduce the overall risk associated with their portfolio but may limit potential returns. Making investments in only one market sector may, if that sector significantly outperforms the overall market, generate superior returns, but should the sector decline then you may experience lower returns than could have been achieved with a broadly diversified portfolio.
How Diversification Reduces or Eliminates Firm-Specific Risk
First, each investment in a diversified portfolio represents only a small percentage of that portfolio. Thus, any risk that increases or reduces the value of that particular investment or group of investments will only have a small impact on the overall portfolio.
Second, the effects of firm-specific actions on the prices of individual assets in a portfolio can be either positive or negative for each asset for any period. Thus, in large portfolios, it can be reasonably argued that positive and negative factors will average out so as not to affect the overall risk level of the total portfolio.
The benefits of diversification can also be shown mathematically:
For investments with equity risk, the risk is best measured by looking at the variance of actual returns around the expected return. In the CAPM, exposure to market risk is measured by market beta. The APM and the multifactor model allow for examining multiple sources of market risk and estimating betas for an investment relative to each source. Regression or proxy model for risk looks for firm characteristics, such as size, that have been correlated with high returns in the past and uses them to measure market risk.
On investments with default risk, the risk is measured by the likelihood that the promised cash flows might not be delivered. Investments with higher default risk usually charge higher interest rates, and the premium that we demand over a riskless rate is called the default premium. Even in the absence of ratings, interest rates will include a default premium that reflects the lenders’ assessments of default risk. These default risk-adjusted interest rates represent the cost of borrowing or debt for a business.
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