Investing in a single asset carries unique risks based on the variability and standard deviation of that asset's historical returns. Diversifying among multiple unrelated assets reduces overall portfolio risk, as poor performance of some assets may be offset by positive returns from others. While any single asset could fail, it is less likely that all assets in a portfolio would fail at the same time by experiencing losses. Therefore, diversification helps stabilize returns and lower risk compared to investing in only a single asset.
3. What is Risk?
In common language Hindi it means
“जोखिम”
a situation involving exposure to danger, harm, or loss.
Risk includes the possibility of losing some or all of the original
investment.
Different versions of risk are usually measured by calculating
the standard deviation of the historical returns or average
returns of a specific investment.
4. What is Returns
In simple Hindi term Returns is defined as
“प्रतिफल”
The gain or loss of a security in a particular period.
The return consists of the income and the capital
gains relative on an investment.
It is usually quoted as a percentage.
5. What is Asset?
In Hindi it means
“संपत्ति”
Something valuable that an entity owns, benefits from,
or has use of, in generating income.
An asset can be (1) something physical, such as cash,
machinery, inventory, land and building
7. Risk & Return on Single Investment
Where will the seagull go? Will it fly toward the sea,
turn around and walk away? Will it look your way or look
to the surf?
This range of possibility is one way to see risk.
Observing how often the bird flies away, compared to
how often it stays can provide us a measure of risk.
8. Probability Distribution
Assessing the risk of an asset requires that we have some sense for
the range of possible outcomes. For example, a judge sentencing a
youthful offender might consider the likelihood of different
scenarios:
worst case (pessimistic), the offender will commit only
another minor crime;
expected case (normal), she will commit no more crimes
best case (optimistic), she will prevent others from
committing crimes
9. Expected Return
What is the expected return when we throw two
dice? Suppose the number you throw represents the
return, and suppose you throw the dice thousands
of times. What would you expect your return to
be on average? We can compute the expected
return for each possible result and then sum these
results.
10. Standard Deviation
This variability can be measured. That is, risk can be quantified!
The most common measure of risk is the standard deviation -- a
numerical measure of the dispersion around the expected value.
Here is how the standard deviation (designated by s ) is calculated
for our two dice probability distributions:
compute the expected return;
square the variance of each return from the expected return;
multiply this by the probability;
sum these weighted values;
calculate the square root of this sum (the standard deviation).
11. Normal Distribution
The probability density of the normal
distribution is: Here, is the mean or
expectation of the distribution (and also its
median and mode).
The parameter is its standard deviation
with its variance then . A random variable
with a Gaussian distribution is said to
be normally distributed and is called
a normal deviate.
12.
13. Coefficient of Variation
What happens when there are two distributions with
different expected returns?
How do you decide which distribution involves greater
dispersion and thus greater risk? For example, suppose you
are presented with two investment strategies.
Plan A Plan B
Expected return 15% 20%
Standard
deviation
5% 6%
Coefficient of
variation
.333 .300
14. Plan A offers a lower expected return, but with less variability, than
Plan B. Which is less risky? Actually, Plan B has less relative risk.
The coefficient of variation -- that is, the ratio of variability to return
-- is higher for Plan A (5/15 = .33) compared to Plan B (6/20 = .30).
There is greater relative risk that returns will deviate from the
expected return under Plan A.
15. Risk of Multiple Assets (Portfolio Risk)
"Put all your eggs in one basket,
and then pay very close attention to that basket."
—Warren Buffet
Why are we told not to put all our eggs in one
basket? If we had two baskets and we tripped,
might we not lose both baskets anyway? Or if we
tripped, but caught ourselves with our right hand,
might we not save the full basket in our left hand?
What are the assumptions implicit in the eggs-in-
one-basket dictum