Studying the Relationship between Risk and Return Finance Essay

The main aim of this case is to find the portfolio that will offer investors the highest expected rate of return for any degree of risk they are willing to tolerate. Extra returns are needed by the investors for taken a higher level of risk. Sandra needed the basic idea on risk-return tradeoff and on portfolio management from Bolton in order to make the right investment. When investors are considering investing in a security market, the problem they face is deciding how much to invest or hold and choosing the best security based on the characteristic of risk-return. 2.0 RELATIONSHIP BETWEEN RISK AND RETURN The risk and return are the process through which Sandra can make decision.

The risk premium serves as the compensation to investors for investing on that particular asset The investment return is the compensation given to investors for the time spends waiting and the worries on the risk of an asset which they invested on.(Brealey,Myers & Marcus, 2009,p.317). Investors uses the historical record to measure the current opportunity cost of capital which is the return that shareholders gives up for investing in a project and probability is used to estimate the possible situation which will occur within the period of investment. (Roses,Westerfield & Jordan,1998,p.367). In appendix A, the utility-company is the best decision based on their coefficient-variation since it has the lowest value in units i.e. having 2.65% of risk, 9.7% of return and 0.27 of coefficient-variation, followed by High-tech-company with 21.91% of risk, 10% of return and 2.19 of coefficient-variation, then Counter-cyclical-company with 12.07% of risk, 5% of return and 2.41 of coefficient-variation. Therefore expected return depend on the risk involved and Investors uses the past record to estimates the future using the method of arithmetic average, variance, standard deviation since he assume that the future will be like the past. A good investor needs to choose a project which has higher return and lower risk. 3.0 HOW BETA RELATES TO INVESTMENT RETURN For Sandra to get good return with less risk when investing on a market portfolio she should able to understand the meaning of beta because it measures non-diversifiable risk to get a high return. Beta is the sensitivity of the return of stock over the variety in market portfolio return. (Brealey,Myers&Marcus 2009,p.340). ItA¿A½s the measure of risk on the portfolio of an individual stock and it account for both stocks for standard deviation and correlation among other securities available in the market.(levy&Alderson,1998,p.307). The market risk premium depends completely on the beta in order to get assets risk premium. Therefore beta is an important determinant of an asset expected return in order to eliminate a systematic risk which cannot be diversified. An average beta is 1.0, risk free rate is 0. Aggressive-stock shows that stocks riskier than the market portfolio but provides larger gain while Defensive-stock shows that stock will fluctuate less than the market which is relatively safer but provides lesser gain. The calculation in appendix C shows the beta for Utility-company as 0.529, High-Tech-company as 0.207 and counter-cyclical-company as -0.356 meaning that all the individual asset are on defensive-stock. The formula is Beta j = Covariance mj / rA¿A½m. The company with the highest risk is Utility-company and the lowest risk is Counter-cyclical-company. Composite index is preferred more than index fund because is a standardized combined indexes which provides useful measures statistically in overall market performance. Also the expected return is more than the index fund and the chances of risk is very low compared with index fund as shown in appendix B, i.e. having return of 18.70% and risk of 4.96% while index fund has only 8.40% of return and 10.72% of risk. 4.0 WHY WE HAVE TO DIVERSIFY OUR INVESTMENT it is better for sandra to diversify in-order to balance the risk and return of any assets. Diversification is a principle designed which reduces the variability of risk by spreading the market portfolio across many investment.( Brealey,Myers &Marcus 2009,p.323). ItA¿A½s the distribution of investors saving among different securities and it reduces investors overall risk of their holding either as losses in one investment or partial profit attained in another investment. (Lee, Finnerty & Norton,1997,p.39). In the calculation shown in appendix D, the right choice is Utility-company which has a risk of 2.65% and return of 9.70% while the risk for Counter-cyclical-company is 12.07 and itA¿A½s return is 5% but needs to be diversified in order to balance each scenario performance of both companies. Diversification is applied by Investing 75% in utility-company and 25% in Counter-cyclical-company which gives a portfolio return of 8.53% and 1.41% of risk. Sandra diversify primary to reduce unnecessary risk in order to maximize the present-value of her lifetime consumption and diversification reduces risk by decreasing the amount of uncertainty of return without reducing expected return. The portfolio risk of a stock depends on whether the return tends to vary or against the return of other portfolio asset. A¿A½Not to put all eggs in one basketA¿A½. The Possible situation which can affect the stock price may be as a result of macroeconomic factors. 5.0 DETERMINING UNDERVALUE AND OVERVALUE FROM SECURITY-MARKET-LINE When Sandra those not want to lose her investment in the market, she needs to understand what SML means in order to make the right decision. Security-market-line shows the standard for investing different fractions of market fund based on the risk and return.(Brealey,Myers&Marcus,2009,p.349). SML signify a linear relationship between beta and the expected return for all the assets.(Levy &Alderson,1998,p.319). The figure above was calculated in appendix C, the individual stock at Beta 0.529 offers 12.24% expected rate of return, risk free rate of 5% and market risk premium of 13.7%. Sandra will not buy when the stock offered a lower rate of return.

The price will drop if nobody decides to hold the stock which is a better buy for Sandra. This will lead to a higher rate of return and the expected return will move to 12.24%, therefore at this point the capital assets pricing model holds at the expected return and the price.

The Utility-company is overvalue because is below the SML line while High-tech-company and Counter-cyclical-company is undervalue because is above the SML. The Capital Asset Pricing Model helps to show that the expected rate of return of all securities and portfolio lie on security market line and also depends completely on the beta. The CAPM is graphically represented by SML. 6.0 THE EFFECT OF INTEREST RATE IN A DIVERFISIFIED PORTFOLIO Sandra needs to focus very well in the interest rate movement in order to make reasonable decision. Capital-Asset-Pricing-Model is described as the relationship between return and risk which states that the expected risk premium on security is equals to its beta times the market risk premium.(Brealey,Myers & Marcus,2009,p.348). It explains the exact linear equilibrium relationship between the beta and the expected rate of return of individual assets and portfolios. (Levy & Alderson,1998, p.322) if Sandra choose a well diversified portfolio, these will be as a result of when the stock more than 12.24%, then diversified investors will like to buy more of that stock which will automatically increase the price and the expected return will decrease until it is at the level of CAPM. CAPM is a recognized instrument which help to adjust risk discount rate through the analysis of portfolio i.e. risk are measured in beta factors and these measures the sensitivity of its return on a quoted shares based on the market movement as a whole. 7.0 INVESTING ON FIXED-INCOME SECURITY When Sandra those not know when the investment is defensive or aggressive, its better to put her money bank on a fixed income security. A project NPV or cost of capital is the amount which is expected to multiply the wealth of current shareholders of a firm and the rules is that if the proposed projectA¿A½s NPV is positive, then invest but if not donA¿A½t invest. (Bodie&Merton,2000,p.168). The project cost of capital is the acceptable minimum expected rate of return on a project with its risk given. (Brealey,Myers &Marcus,2009,p.357). If Sandra prefers to put all her money in fixed income securities, then the cash-flow of the project needs to be calculated. If for example the future interest rate of return is 18%, risk free offers a return of 5% and expected market risk premium is 13.7% with zero beta: r=rf+B(rm-rf), = 5+(0x13.7)= 5%, then since the expected return is 18% while the cost of capital is 5%, Sandra should go ahead but if compared with the exact project return of 18.7% company cost of capital, then the project is not worthwhile. Furthermore, in the cost of capital, if the market portfolio has the same risk with the project and the beta is 1.0, it means that its still worth investing on even though the project appearance is less attractive. 8.0 HOT TIPS ON GROWTH RATE FOR UNDERVALUE STOCK Hot tip is an important idea given to Sandra to monitor her investment knowing whether She is in right track or not. when firm stock are repurchased, the stock are considered to be undervalued, meaning that the market is less than the present value of future stock expected cash-flow and this decision is concluded when management uses Present Value evaluation models. (Levy & Alderson,1998,p.478). When the future investment opportunities which are expected to yield a rate of return is greater than the required risk adjusted rate of the market.( Bodie & Merton,2000,p.242) Therefore hot tips regarding undervalue stock is an identified movement of stock growth knowing up-to-date and valuable information on when to buy stock which guarantees successful trading on the stock market. This superior knowledge and strategy makes Sandra to have confidence, secure and buy right stock at the right time with excellent return not minding what the market will be in the future. 9.0 DIVERSIFYING EQUALLY IN THE STOCK OF TWO COMPANIES Diversifying equally in the companies is a good choice for Sandra so as to balance her risk and return between the companies which can sometimes eliminate risk completely. the calculation shown in Appendix E, it explains that High-tech-company has higher return of 10%, higher risk of 21.91% and beta of 0.207 while counter-cyclical-company has lower return of 5%, lower risk of 12.07% and beta of -0.356, this is difficult to choose without beta but using the beta method will now help Sandra to make the right decision. When Sandra invests her money equally on the two companies, the expected return will be 7.50% and the risk will be 6.63%, these shows that when two companies are joined together, the volatility will decrease as a result of the performance in each scenario. Finally, the inverse relationship between the two companyA¿A½s return mean that adding Counter-cyclical-company in all the High-tech-company stabilizes the portfolio returns.

The Counter-cyclical-company reduced the return performance of the High-tech-company but improving the worst-case return. 10.0 INVESTING 70% AND 30% IN A DIVERSIFIED PORTFOLIO An investor that invested with index-fund with 70:30 is also a good choice except that the risk is highier compared with 50:50 above. The calculation shown in appendix F, explains that High-tech-company has return of 10% and risk of 21.91% while index fund has return of 8.4% and risk of 10.72%. To stabilize the risk, the two components will be combined through diversification using 70:30 respectively for High-tech-company and index fund and the result shows a return of 9.52% and risk of 18.54%. This combination of 70%:30% is good but using 30%:70% is much better as shown in appendix G. The returns will be 8.88% and risk is 14.06. The reason is because the different between 70%:30% and 30%:70% for High-tech-company and index fund is that, the return difference is only 0.64 but the risk is reduced more with 4.48. Investing more on index-fund is much better because it is an investment made which has rules that are held constant not minding the movement of the market and it is usually an exchange trade/mutual-fund constructed with a portfolio to track the market index components. Also when measuring the amount of risk per unit of return, 70%:30% gives 1.95 but 30%:70% gives 1.58. 11.0 BEST SUGGESTION ON DIVERSIFIED PORTFOLIO The possible portfolio combination for Sandra that is better than 30%:70% in High-tech-company and index fund is investing 10%:90% as shown in Appendix H, because when measured per unit of risk over the return it will be 1.38 even though the return is still reduced to 8.56% but the risk is also reduced more by 11.83%. If Sandra choose this diversified portfolio itA¿A½s a good choice since it is the principal key relies mainly on statistical approximations in order to stabilize any chances of risk and return in her investment, no matter the fluctuation in the market or economic crisis around the globe or better still take the risk by investing in 30%:70% since risk aversion explains that high security risk result to low price and high required return. 12.0 CONCLUSION Any comprehensive collection of risk measures captures the following characteristic of the entire financial system which includes leverage, liquidity, correlation, concentration, sensitivity and connectedness. Therefore weather a particular stock moves up or down is not that important to investors but what is important is the return and risk of that portfolio stock. Also using beta to estimate a systematic risk which cannot be diversified or better still invest fully in a fixed market income.

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