Relationship Between Risk and Rate of Return
Relationship between risk and rate of return is an important key concept on any investment, because it drives many foundational theoretical models such as Capital Asset Pricing Model. The model predicts that the relationship between the rate of return on any investment is linear as measured using the beta method, above the risk-free rate and the non-diversifiable risk. Many investors and aspiring investors would love to invest in an investment that is of high return and low risk, however the rule is that the investment with high or greatest expected rate of return is the riskiest one. Even though, the relationship between the risk and rate of return is not perfectly linear, the higher the risk the greater the returns(Ruefli, Collins, & Lacugna, 1999). A risk-free investment can be defined as an investment with guaranteed rate of return and no risk, but in practical world it does not apply and involved investments are virtual. Risk Premium is whereby the rete of returns calculations changes with the introduction of risk factor.
The pyramid below clearly shows the relationship between the risk and rate of return, the higher the risk the higher the rate of return and the lower the risk, the lower the rate of return.
Relationship between risk and return
Portfolios and Managing Risk
A portfolio is defined as a collection of different investments. Majority of smart investors don’t put all their investment in one basket, instead they choose to invest in a collection of investments. Often these portfolios do have different levels returns and risk, and therefore this will allow the investor to manipulate his or her level of risk and the expected returns to his advantage. Investment diversification is the way to go in minimizing the risk and maximizing on the returns, different investments have different levels of risks and different rates of return.
To minimize the risk and maximize the returns, and investor would adopt an active portfolio strategy. In this case the investor will use the economic and financial indicators to study and analyze the market and take advantage of the situation. Active portfolio would take into considerations the sector rotation, market timing, conceptualization and stock selection. If the investors invest at the right market time, right sector rotation and in the right stock, he or she will minimize the risk and increase the returns.
Arguments for Investment Diversification
As the saying goes, one should not put his or her eggs in one basket, so does an investor. Putting all of your investment in one investment increases the risk and reduces the returns. However, every investor would like to maximize on his or her investment by maximizing on the rate of returns and minimizing on the risk. Investment involves taking a well calculated risk, the more the risk, the higher the returns. Taking a less risky investment means investor would expect low rate of return, but a sure way to reduce risk while increasing the rate of returns is through diversification. Diversification is spreading of investment among different classes of assets, reducing the exposure to asset class, market and economic risks.
Smart investors diversify their investment to assets that are not likely to face risk(Bond, Hwang, Mitchell, & Satchell, 2007), and with different combination of investments the risk is spread among the different asset classes as shown in the table below.
|Diversification in investment||Reduced risk|
|Countercyclical and cyclical||Economic|
|Sectors of the economy||Industry|
|Different types of investments||Asset class|
|Kinds of firms||Company|
Diversification involves three steps namely: security selection, asset allocation and capital allocation. The pyramid below shows the three levels of diversification, investment is strategic taking of risk and diversification will help spread the risk and increase the returns.
How Bonds, Stocks, Metals, Real Estate and Global Funds is Used in Diversified Portfolio
Concentrating investment in one type of asset classes concentrates the risk, minimizing the returns. For an investor to reap big from his investment, he needs to spread his investment, diversify, to maximize on the return and minimize on risk. Some of the investment fields to diversify to includes; bonds, stocks, metals, real estate, and global funds. Bonds and stock do not generally sync together and therefore one should invest in different types of bonds and stocks. In the recent past there have been a sharp decline in the stock prices, with some stock markets being affected more than others. For example, in US a smart investor would split his investments between US large cap and US small cap to cushion the risk. Diversification in bonds will involve holding bonds in a variety of corporations and foreign bonds. Value of metals, especially precious ones such as gold, is influenced with shifts in sentiment, and smart investor would allocate his capital to different types of metals. In the recent past it has been demonstrated that real estate, both direct and indirect, and infrastructure is on growth and therefore a great field to diversify to. Investors will spread their capital between infrastructure and real estate. To cushion himself from huge losses, the investor will spread his investment in bonds, stocks, metals, real estate, and global funds.
Concept of the Efficient Frontier and How to Use it to Determine an Asset Portfolio for a Specified Investor
Efficient frontier is defined as a combination of different sets of securities that can maximize the expected return at a lower or reduced risk level. In other words, its is a set of optimal portfolios that will improve on expected return and reduce through spreading the risk. On the efficient frontier, there is at least one point that corresponds to construction of all the available investments, with its corresponding risk and return. This portfolio point will enable investors to project and understand the expected return and risk of the diversified investment. From the efficient frontier curve, we can find the frontier point that will correspond to the investment that the investor wants to invest in, from there it would be easy to advise him from the projection of the expected return and the corresponding level of risk. Relationship of the securities matters a lot in efficient frontier, the lower the covariance, known as standard deviation is associated with small risks(Fabozzi, Markowitz, Kolm, & Gupta, 2012).
The frontier curve is curved due to diminishing marginal returns to risk. investors will choose portfolios with high expected returns at lowest possible level of risk.
The Ideal Portfolio to Maximize the Rate of Return for the Short Term and Long Term
Taking into considerations the projections of the next coming year, smart investors would remain diligent in balancing their investment portfolios. Because of factors such as politics, debts and expected interest rates that may affect the investment, the best way for investors to cushion themselves is through diversification. The effective portfolio for both long-term and shorter-term investment in the next one year and near future will comprise a combination of the following set of investments. Real estate or residential homes investment is on the rise and home ownership rates is rising at a higher rate, if an investor chooses to invest in this invest, he his set to reap big in short-term investments. Another sector to diversify to is the manufacturing industry, currently and in the future, the manufacturing sector is set to expand tremendously over the world. For long-term investment, an investor would add this to his portfolio.
Staying in stock- monetary policies are being reviewed with the aim of tightening the policies, therefore the returns on stocks will be high, and value stock is favorable as compared to growth stock. Corporates bonds and going global on investment is another set of portfolios to diversify to. The difference between short-term and long-term investment is that they do have different risks,(Cremers, Pareek, & Sautner, 2000) such as fluctuations and volatility, in long-term investment whereas short-term investment will be affected with purchasing power. They do meet different goals, different needs at different times and they carry different expectations. A smart investor will mix both the long term and short-term effective portfolio investment to get returns that would meet his needs at different times.
Bond, S., Hwang, S., Mitchell, P., & Satchell, S. (2007). Asset allocation in the modern world. Technical Report.
Cremers, M., Pareek, A., & Sautner, Z. (2000). Short-Term Investors, Long-Term Investments, and Firm Value: Evidence from Russell 2000 Index Inclusions. Ankur and Sautner, Zacharias, Short-Term Investors, Long-Term Investments, and Firm Value: Evidence from Russell.
Fabozzi, F. J., Markowitz, H. M., Kolm, P. N., & Gupta, F. (2012). Mean‐Variance Model for Portfolio Selection. Encyclopedia of Financial Models.
Ruefli, T. W., Collins, J. M., & Lacugna, J. R. (1999). Risk measures in strategic management research: auld lang syne? Strategic management journal, 20(2), 167-194.
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