Week 4 Discussion 1: Risk, Return, And Diversification ✓ Solved

Week 4 Discussion 1 Risk Return And Diversificationimagine You

Imagine you have the option to invest in three different opportunities: A, B, and C. You have analyzed the risks and classified them as low-risk, medium-risk, and high-risk, respectively. Which of these three opportunities would you need to provide the greatest return in order to invest in it? Now let's say the returns of opportunities A and B are highly correlated with the market as a whole, but those of opportunity C have a very low correlation with the overall market. Would this information potentially change the required return you imposed on the opportunities in order to invest in them? If so, why?

Now imagine that another investor views the risks to be the opposite of your view (that is, she views opportunity C to be the least risky, followed by B and then A). Assume your view of the risks is the same as described earlier. Does this change the required return you need in order to invest in the different opportunities? Try and relate your explanations to the concepts from the readings this week.

Paper For Above Instructions

Understanding the concepts of risk, return, and diversification is paramount in investment decision-making. When evaluating investment opportunities A, B, and C, categorized as low-risk, medium-risk, and high-risk, respectively, it is essential to comprehend the required return demanded by each based upon these risk assessments. In general, as the risk associated with an investment increases, so too does the required return, founded on the risk-return tradeoff principle (Sharpe, 1964).

Given the classification of the opportunities A, B, and C as low-risk, medium-risk, and high-risk, respectively, it follows that opportunity C, being high-risk, would necessitate the highest return in order to justify the inherent risk involved with the investment. Conversely, opportunity A, categorized as low-risk, requires the least return to be considered a viable investment opportunity. The underlying rationale is that investors expect to be compensated for taking on additional risk; therefore, a higher expected return is necessary for riskier investments (Malkiel, 2019).

The aspect of correlation with the market also plays a critical role in determining required returns. Opportunities A and B are positively correlated with market returns, suggesting they will follow broader market trends. Therefore, shifts in the market would impact these investments' returns positively or negatively. On the other hand, opportunity C, which exhibits low correlation with the market, may not respond similarly to market fluctuations (Elton & Gruber, 1997). This dissociation from market movements can potentially lower the necessary return required to entice an investment in opportunity C. Low correlation offers a form of diversification that may be attractive to risk-averse investors who seek to minimize their portfolio's overall volatility (Markowitz, 1952).

If the correlation aspect is factored into the required returns for investment opportunities, it brings forth a nuanced consideration. Opportunity C, with its low correlation to the market, may provide a hedge during market downturns, which could lead investors to view it as a more favorable investment despite its high-risk classification. This suggests that the actual required return could be lower for opportunity C, as its unique risk profile offers potential diversification benefits that may mitigate overall portfolio risk (Statman, 1987).

When contemplating a scenario where another investor perceives the risk hierarchy differently—considering opportunity C as the least risky followed by B and A—the required returns for these investment opportunities become subject to reevaluation based on individual risk perception. This differential perspective implies that the required return for each opportunity might vary significantly based on investors' risk tolerance and market outlook (Lintner, 1965).

For the initial investor who perceives opportunity C as high-risk, required compensation is inherently higher, whereas the alternate investor's assessment could lead her to demand a lower return for what she views as the least risky option. This dichotomy highlights the subjective nature of risk assessment in finance. It illustrates how necessity for higher returns can pivot based on individual perception of risk versus the actual market dynamics of the investments in question (Fama & French, 1993).

Moreover, this discussion connects seamlessly to the concepts discussed in this week’s readings that broadly elucidate the influence of market sentiment and personal risk tolerance on required returns. Investors typically adjust their expected returns based on not just empirical data but also on their emotional responses to risk and reward scenarios, making the investment landscape deeply individualistic despite the general rules that govern risk and return (Bekaert & Harvey, 1997).

In conclusion, investment opportunities A, B, and C exhibit divergent risks and returns influenced by both their inherent risks and correlation with market returns. As the required return adjusts in relation to perceived risks, it becomes apparent that diversification strategies can influence investment choices significantly. Sustainable investment decisions depend on comprehensive risk assessments and individual investor perceptions, underscoring the multifaceted relationship between risk, return, and diversification in financial markets.

References

• Bekaert, G., & Harvey, C. R. (1997). Emerging equity market volatility. Journal of Financial Economics, 43(1), 29-77.
• Elton, E. J., & Gruber, M. J. (1997). Modern Portfolio Theory and Investment Analysis. John Wiley & Sons.
• Fama, E. F., & French, K. R. (1993). Common risk factors in the returns on stocks and bonds. Journal of Financial Economics, 33(1), 3-56.
• Lintner, J. (1965). The valuation of risky assets and the selection of risky investments in stock portfolios and capital budgets. Review of Economics and Statistics, 47(1), 13-37.
• Malkiel, B. G. (2019). A Random Walk Down Wall Street. W. W. Norton & Company.
• Markowitz, H. (1952). Portfolio Selection. The Journal of Finance, 7(1), 77-91.
• Sharpe, W. F. (1964). Capital asset prices: A theory of market equilibrium under conditions of risk. The Journal of Finance, 19(3), 425-442.
• Statman, M. (1987). How many stocks make a diversified portfolio? Journal of Financial and Quantitative Analysis, 22(3), 353-363.