What is Risk and Return?

■ Risk: In investment terms, risk is often described as the level of

unpredictability of returns or the chances that returns will be different
(higher or lower) than expected.
Components of Risk:
– Systematic Risk (Market Risk) : arises out of economy wide factors
which affect every security. This is uncontrollable.
– Unsystematic Risk (Unique Risk): arises out of firm specific factors.

■ Return: Return, in simplest terms, is the money made or lost on an

investment.
What is a Portfolio?
A portfolio is simply a specific combination of securities, usually defined by
portfolio weights that sum to 1.

Assumption: Portfolio weights summarize all relevant information.

Measuring Portfolio Risk and Return
■  Both risk and return of a portfolio depend on the following:
– Risk and return of the individual securities in the portfolio (σi and Rj,
respectively)
– Proportion of the total investible funds allocated to different
securities (wi)
 
– Interrelationship between returns of different securities (ρ1,2 σ1 σ2)
Unique Risk can be eliminated by investing in a portfolio of securities of an individual security.
This process is called Diversification.
Diversification is a strategy to reduce risk by spreading the portfolio across many investments.

Systematic Risk affects every security and hence it cannot be eliminated through diversification.
Why not pick the best stock instead of forming a Portfolio?

■ We don’t know which stock is best!

■ Portfolios provide diversification, reducing unnecessary risks.

How do we construct a “Good” Portfolio?

■ What does “good” mean?

■ What characteristics do we care about for a given portfolio?
– Risk and Reward (Returns)
■ Investors like higher expected returns
■ Investors dislike risk