Getting cranked up again in here. We’ll have a test next week, which I’ll have to take on Wednesday. Next Monday is the Republican convention, where I expect to be busy all day.Investment Returns — Basically the rate of change in investment.
(Final Amount – Initial Investment Amount) / Initial Investment Amount
Higher returns are better, ceteris paribus. However, All else is seldom equal. In general, the probability of earning a favorable or unfavorable return is related to the risk of sub-par returns. Higher returns are associated with higher risk of poor returns.
The probability distribution of an investment is a listing of all possible outcomes of that investment and the probability of each outcome occurring.
Investments with higher returns are more desirable than investments with lower returns. On the other hand, investments with low risk are more desirable than investments with high risk. An investor has to balance desired return with acceptable risk.
Investors are assumed to be risk averse. This means that if two investments have the same expected return, investors will choose to invest in the alternative with lower risk. Therefore, for a higher-risk investment to be desirable, it must offer a higher return. This additional return is called a risk premium.
A normal standard deviation for a stock is about 35%. Standard deviation for a portfolio should be much smaller. For large portfolios, risk will often converge around 20%.  This 20% risk level is considered to be market risk, as opposed to diversifiable risk. Market risk is that risk which affects all or virtually all investments in a portfolio equally. If the economy tanks, all stocks generally get worse, regardless of individual performance.
Market risk is also known as beta risk, non-diversifiable risk, or systematic risk.
Diversifiable risk is specific to individual stocks, and is also referred to as idiosyncratic risk, unsystematic risk, or firm-specific risk.
Investors who hold a single-stock portfolio should and are not compensated for the extra risk associated with not diversifying.
Capital Asset Pricing Model — CAPM is a model linking risk and required returns. CAPM suggests that a stock’s required return equals the risk-free return plus a risk premium that reflects the stock’s risk after diversification
CAPM models assign a beta value to individual stocks. Beta is the volatility of stock. A beta of 1.0 means the stock is equal in risk to the hypothetical average stock. If beta is greater than 1.0, the stock is riskier than the average. If beta is less than 1.0, the stock is less risky than the average. Most stocks have betas in the range of .5 to 1.5. It is possible for a stock to have a negative beta, if that stock is negatively correlated with the market as a whole.
The CAPM model is not perfect. It is suspected that other factors exist which are not adequately included in the model at this time.
Test next week. Chapters 2, 6, 7, and 8. Same format as last time. I’ll have to take the test on Wednesday. 4 PM, room 1438.