Q1 Answer
The risk in financial investment refers to the events that may affect the attainment of a financial goal. On the other hand, Paul (2012) defines the rate of return as the gains from the investment that an investor receives after a given duration of time. Both risk and rate of return can be said to be directly related. This is to mean that when the risk of investment is very high, then the rate of return is very high. However, this does not mean that always when an investor takes high risks will gain high returns, He or she may also suffer a great loss for investing in high-risk investments. The truth is when an investor takes a lower risk the chance he or she would expect at the end of the investment time is a lower return. This means that risk and the rate of return have a positive correlation.
Investors take the issue of risk and rate of return to be very different, and this can be explained by various risk attitudes possessed by investors. There are three attitudes that explain how investors take the issue of risk and return. Firstly, some investors can be said to be risk seekers meaning that they would prefer to take high risks with an expectation of high returns at the end. Secondly, other investors are risk averse implying that they avoid risk at all levels and they are contented with what they attain at the end of the financial investment. Finally, the last lot of investors is those investors who are indifferent about the risk implying that they do not care what happens provided they invest and receive some returns (Wang, 2013).
Q2 Answer
Portfolio diversification is the only way through which an investor can minimize risks and maximize returns. The process involves investing in many investments with different risk levels. Diversification formulation that could assist in maximizing returns and minimizing risks require looking for a diversity of investment tools such as stocks, real estate, and bonds among many others. Besides, it is worth to note that these investments need to vary in the level of the risks they possess. Also, it is important to ensure that the investments have different rates of return. As a result, it becomes easier for the high returns to offset the losses that occur. Careful consideration is important during the selection of the risk to ensure that they met those provisions. Finally, it is good to ensure that the investments come from different industries so as to have different risks attached to the investments. However, considering only one industry implies that the risks associated will be the same and might not be minimized through diversification.
Q3 Answer
One argument about portfolio diversification is the need to understand whether it does away with all risks associated with an investment. In other words, portfolio diversification helps in offsetting all the risks associated with the investment. The answer to this argument depends on the type of risk associated with the investment. There are two types of risks namely diversifiable risk and diversifiable risk. Diversifiable risk which is also referred to as specific or unsystematic risk is that risk that the investor can edge out through diversification. In other words, it is a risk that can be minimized in investment. An outstanding example of such risk is a change in regulation or change in management among others. In such a circumstance, one can support the argument by saying that portfolio diversification leads to a reduction of risk to a great extent.
On the other hand, an undiversifiable risk which also referred to as systematic risk refers to that risk that cannot be controlled and has a great effect on the overall outcome of the investment. This means that when an investor ventures in a portfolio of investments with such risks he or she will not be able to control all the risks associated with the investment. Some examples of such risks as provided by Wang (2013) include interest rates and economic recessions. For instance, economic recession will take its course despite the measures that countries may take and will affect investments. This can impel one to counter the argument that portfolio diversification plays a role in controlling all the risks associated with an investment.
Q4 Answer
Stocks, bonds, real estate, metals and global funds are some of the investments that yield high gains to the investor in the long run when diversified. An investor can use them for diversification because they have different rates of return as well as different risks. In a diversified portfolio, an investor can use stocks and bonds to purchase precious metals. Besides, an investor may consider splitting stocks and investing them because they provide diversification benefits. On the other hand, bonds will give the investor both return on capital and income. However, they are subject to interest rate and inflation risks. This is to mean that an investor may consider shortening the duration of investing in bonds.
Furthermore, real estate investment in a portfolio may assist in continuous yield income. However, they are very sensitive to the interest rates. Finally, global funds provide an investor with foreign returns and have exposure to foreign exchange rates. The analysis above shows that these investments have different rates of return and risks levels. This makes them qualify for portfolio diversification with proper planning.
Q5 Answer
The efficient frontier portfolio would refer to investment in combined securities that will lead to high returns at any level of risk. It is worth to understand that efficient frontier connects all the efficient portfolios. This is to imply that if focuses on maintaining a high level of return for any given risk. In fact, it represents the best combination of investments in a portfolio. The analysis of efficient frontier can be well illustrated by the relationship that exists between the rate of return and standard deviation (Baumol, 1970).
The figure above shows the relation between portfolios rates of return and the standard deviation which stands for risk tolerance level of the portfolios. Any point on the curve indicates optimal portfolios that imply that the portfolio can yield high returns at any risk level. However, any point below the curve clearly indicates that the portfolios are unable to provide high returns for any level of risk. Therefore, an investor should focus on diversifying his or her portfolios to ensure that they lie on the frontier curve line so as to yield optimal results (Best, 2010).
Markowitz (1991) reveals that an investor who wants to attain the optimal portfolio needs to consider investing in a combination of assets with different rates of return. Also, he or she must consider those investments with different risk levels. This means that their combination will assist in yielding high returns which will help in minimizing the risks. Still, it becomes possible to have all the portfolios lying on the frontier curve line when their rates of return and risk tolerance are plotted together.
The economic outlook for next year seems to be represented by slow growth. This is to imply that investors can invest more in stocks, bonds and real estate in a diversified portfolio in both short term and long term. There is a distinction between short term and long term portfolio investments. Firstly, investing in the short-term portfolio will present an investor with high risks and the rate of return may not be as expected. This is to mean that diversification of the combined investments may not yield good results for the investor. Investing in a short-term portfolio is very sudden and may crop in some risks whose minimization may be very difficult within a short duration thus influencing the returns negatively. This is to imply that an investor presented with time may look for strategies to overcome the risks.
However, in long run portfolio investment, the rate of return looks more stable at any level of risk. This is because the investor has enough time to gauge the risks involved and make the necessary changes as time goes on thus fostering stability in returns. For instance, an investment in stocks for long term presents a low risk for a loss to the investor. In fact, short-term portfolio investment focus on saving funds for a future duration as one receive some amount of returns. This means that there is a great difference in managing risks for short term and long term portfolio investments.
References
Baumol, W. J. (1970). Portfolio theory: The selection of asset combinations. New-York: General Learning Press.
Best, M. J. (2010). Portfolio optimization. Boca Raton: Chapman & Hall/CRC.
Markowitz, H. (1991). Portfolio selection: Efficient diversification of investments. Cambridge, MA: B. Blackwell.
Paul, S. K. (2012). Advanced financial management. S.l.: New Central Book Agency.
Wang, P. (2013). Investment and portfolio analysis. North Ryde, NSW: McGraw-Hill.
