The process of combining numerous securities to reduce risk is known as diversification. It is necessary to consider the impact of covariance or correlation on portfolio risk more closely to understand the mechanism and power of diversification.Let’s study the issue category-wise −when security returns are perfectly positively correlated, when security returns are perfectly negatively correlated, andwhen security returns are not correlated.Security Returns Perfectly Positively CorrelatedWhen net assets returns are perfectly and positively correlated, the given correlation coefficient between the two securities will be +1. Thus, the returns of the two securities will move up or down together. The portfolio variance ... Read More

Diversification in InvestmentIf the market conditions are normal, diversification is an efficient way to reduce risk. Holding just one type of investment can potentially pose a threat to your investment if the securities of your industry fail. In such conditions, you could lose all of your money. A well-diversified portfolio with a variety of different investments will save you when one investment performs badly in the market. As it is unlikely that all of the investments will perform badly at the same time, the profits you earn on the investments of other assets that perform well will offset the losses ... Read More

Unsystematic risk is related to the internal risk factors of the organization. It is also called specific risk, idiosyncratic risk, diversifiable risk, or residual risk. An unsystematic risk occurs due to any event for which the business is not prepared, and which disrupts the general and smooth functioning of the firm’s business.Some of the factors that lead to unsystematic risk are −The inefficiency of the managementChanges in the capital structureLiquidity crunch in the businessFlaws in the business modelProduction of non-desirable productsLabour strikesUnsystematic risk can be diversified and so can be avoided. It is a fact that one can diversify their ... Read More

A Characteristic Line (CL) measures the risk and the related return of a security. The returns of a security at different times are plotted on a line that takes a form of a straight line which is the characteristics line (CL).The CL represents the performance of the security in comparison to the market risks. The stock returns are placed on the Y-axis of a graph and the stock market returns are placed on the X-axis. The beta coefficient of the graph provides the slope of the characteristic line. The slope and standard deviation of the characteristic line, define the asset’s ... Read More

The risk that occurs due to the system of economy is known as systematic risk. Systematic risk is complex in nature and is beyond the control of an individual or a specific company. In general, all investments and securities are prone to such kinds of risk.Systemic risk includes unforeseen events that happen automatically, making it uncontrollable and beyond the will of a single person or company. Systemic risk usually impacts the entire industry rather than a single company or security.Note − Systemic risks cannot be avoided by diversification.Example #1: The 1866 Overend and Gurney CollapseOverend and Gurney was a brokerage ... Read More

Capital Allocation Line (CAL) and Optimal PortfolioThe Capital Allocation Line (CAL) is a line that shows the risk-and-reward profile of assets and can be utilized to build an optimal portfolio. The process of building the CAL for a set of portfolios is given below.Portfolio Expected Return and VarianceLet’s construct a portfolio with only two risky assets for the sake of simplicity and understanding. The portfolio’s expected return is the weighted average of each individual assets’ expected returns, and is calculated as −$$\mathrm{𝐸(𝑅_{𝑝}) = 𝑤_{1}\:𝐸(𝑅_{1}) + 𝑤_{2} \:𝐸(𝑅_{2})}$$Where$𝑤_{1}$ and $𝑤_{1}$ are the weights for the two assets, and$𝐸(𝑅_{1})$ and $𝐸(𝑅_{2})$ are ... Read More

A risk-free asset comes with a virtually guaranteed return. Usually, all investments have a degree of risk associated with them, so the term "risk-free" is used to mean the assets that are sufficiently safe so that investors can remain sure to get a return on their investment that is somehow close to the return predicted for the asset while investing.A risk-free asset has a definite future return, whatever the risk of the assets is. This type of asset often provides a certain return providing investors a level of assurance over the return from the.The United States Treasury Bills are a ... Read More

The Arithmetic Average Return is calculated by adding the rate of returns of "n" sub-periods and then dividing the result by "n". In other words, the returns of "n" sub-periods are added and then divided by "n" to find the value of the average return. As it is also the process of finding the average of a series of numbers, the average return is sometimes called as "Arithmetic Average Return".Here is the formula to calculate Arithmetic Average Return −$$\mathrm{Average\:Return =\frac{Total\:Value\:of\:the\:Return}{Total\:Number\:of \:Returns}}$$Investors and market analysts normally use the arithmetic average return to check the past performance of a stock. It is ... Read More

The typical reason for an investor to invest in a financial instrument is to make current income from dividends and interest income. For a stable company, the investments will earn a reasonable return that is the Expected Rate of Return (ERR) on given investments. Some investments such as debentures, bank deposits, public deposits, bonds, etc. carry a predetermined fixed rate of return that is usually payable periodically.Note − The sole aim of the investor investing in a single asset is to get the maximum returns. Some fixed income instruments offer less returns, but they are less risky too. Increasingly risky ... Read More

Present Value of Growth Opportunities or PVGO represents the component of a company’s share value that relates to expectations of the investors in the growth of earnings. PVGO is the difference between the total value of a company’s shares from which the net present value of its earnings is deducted, assuming there is no growth in the values of the share. PVGO is also known as "value of growth".A company’s future income can be better represented in two layers: the first layer represents a perpetuity having constant return and the second layer represents the future growth in earnings.$$\mathrm{𝑉_{0} = PV_{NG} ... Read More