Taking Risk

The risk of an investment is defined as the difference between the expected and actual returns of the investment. While making an investment, there is the risk of making a profit, a loss, or even losing the entire initial investment. Unsystematic risk and systematic risk are the two types of risks. Unsystematic risk is risk connected with the company in which an investor invests, which can be mitigated through diversification. Systemic risks, on the other hand, are hazards that affect the entire market and cannot be mitigated (Ang &Liu, 2015). Calculation of standard deviation of average returns of a particular investment is one major way of measuring risk.High degree of risk is indicated by high standard deviation and vice versa. Investments with a high level of risks always give high returns while investments with low level of risk give low returns (Ang &Liu, 2015).

Firm-specific risks are risks specific to a particular company, and that affects a small percentage of assets. These risks arise as a result of uncertain events affecting the company or small group of companies. One source of a firm’s specific risk is a rumor concerning one stock. For instance, an unexpected strike by the workers of a company, or a new governmental regulation affecting a particular group of companies. This kind of risk can be diversified unlike market risk (Bova & Hammond, 2013).

Market risks are the risk of loses caused by factors that affect the entire market. Sources of market risks include inflation, foreign exchange fluctuations, stock price fluctuations and commodity price fluctuations. This risk cannot be diversified because it affects all the industries equally (Bova & Hammond, 2013).

The coefficient of variation is the ratio of standard deviation to the mean. Though it is widely used in the quantitative analysis to measure probability distributions, in finance, it is used in comparing relative risk of investments. Unlike standard deviation, a coefficient of variation (COV) is a better indicator of risk among different securities of different risk levels (Raudszus, 2012). For instance, suppose two different stocks are offering different returns and have different standard deviations. Stock A has expected return of 15% and a standard deviation of 10% and stock B has expected return of 10% and a standard deviation of 5%. Then Stock B is the better investment having COV of 0.5 (5% / 10%) which is less than the COV of Stock A (10% / 15%, or 0.67).

Part II

Solutions to Problems

Two years ago, Conglomco stock ended at $73.02 per share. Last year, the stock paid a $0.34 per share dividend. Conglomco stock ended last year at $77.24. If you owned 200 shares of Conglomco stock, what were your dollar return and percent return last year?

Total investment = $73.02 * 200 = $14,604

Capital gain = ($77.24 - $73.02) * 200 = $844

Dividend received = $0.34 * 200 = $68

Total dollars return = $844 + $68 = $912

Total percentage return = $912 / $14,604 = 6.24

Calculate the coefficient of variation for the following three stocks. Then rank them by their level of total risk, from highest to lowest:

Conglomco has an average return of 11 percent and standard deviation of 24 percent.

CV = Standard deviation 24% / Average return 11% = 2.18

Supercorp has an average return of 16 percent and standard deviation of 37 percent.

CV = Standard deviation 37% / average return 16% = 2.31

Megaorg has an average return of 10 percent and standard deviation of 29 percent.

CV = standard deviation 29% / average return 10% = 2.90

Risk Ranking

1. Megaorg- highest risk

2. Supercorp- Medium Risk

3. Conglomco- Lowest Risk

Year-to-date, Conglomco has earned a −1.64 percent return, Supercorp has earned a 5.69 percent return, and Megaorg has earned a 0.23 percent return. If your portfolio is made up of 40 percent Conglomco stock, 30 percent Supercorp stock, and 30 percent Megaorg stock, what is your portfolio return?

Weight of Supercorp = 0.30

Return of Supercorp = 5.69%

Weight of Megaorg = 0.30

Return of Megaorg = 0.23%

Weight of Conglomco = 0.40

Return of Conglomco = -1.64%

Portfolio return = 0.40 * (-1.64%) + 0.30 * 5.69% + 0.30 * 0.23% = 1.12%

References

Ang, A., Liu, J., & National Bureau of Economic Research. (2015). Risk, return and dividends. Cambridge, MA: National Bureau of Economic Research.

Bova, A., Hammond, P. B., & Leibowitz, M. L. (2013). The endowment model of investing: Return, risk, and diversification. Hoboken, NJ: Wiley.

Raudszus, M. H. (2012). Financial Return Risk and the Effect on Shareholder Wealth: How M&A Announcements and Banking Crisis Events Affect Stock Mean Returns and Stock Return Risk A Compendium of Five Empirical Studies across Selective Industries. Frankfurt: Peter Lang GmbH, Internationaler Verlag der Wissenschaften.