Investment Risk
The probability of earning a low or negative actual return
Risk
The chance that some unfavorable event will occur that will result in an investment’s actual return being different than the expected return
Stand-alone Risk
The risk that an investor would face if they only owned one asset
Portfolio Risk
The chance that the overall mix of investments in a portfolio will lose value or not perform as expected
Probability Distribution
A listing of all possible outcomes and the probability of each occurrence happening
Standard Deviation
Measure of how much dispersion observed data has from the mean or expected value
Mean
The average, or expected value, of a population/sample
Expected Return
Mean value of probability weighted expected returns
Variance
How spread out the possible returns of an investment are
Correlation Coefficient (p)
A measure of how two securities move in relation to each other
Perfect Correlation (1)
Two securities move in lockstep with each other
Perfect Negative Correlation (-1)
Two securities move in exact opposite direction of each other
Zero Correlation
Movements are not linearly related
- Random movement
Coefficient of Variation
A standardized measure of dispersion about the expected value, that shows the risk per unit of return
Risk Aversion
Assumes investors dislike risk and require higher rates of return to encourage them to hold riskier securities
Risk Premium
The difference between the return on a risky asset and a riskless asset, which serves as compensation for investors to hold riskier securities
Stand-Alone Risk (Equation)
Diversifiable Risk + Market Risk
Diversifiable Risk
“Unsystematic risk” portion of security’s stand-alone risk that can be eliminated through diversification
Market Risk
“Systematic risk” portion of a security’s stand-alone risk that cannot be eliminated through diversification
- Relates to things beyond control of the firm like inflation, economy, war, interest rates
Capital Asset Pricing Model (CAPM)
Model linking risk and required returns
- tells you the return an investment should earn based on how risky it is compared to the overall market
S&P 500
Tracks the stocks of 500 of the largest companies in US
- Often viewed as proxy for the market portfolio
Russell 3000
Tracks the largest 3000 US stocks
Wilshire 5000
Tries to track all publicly US stocks
Beta
Measures a stock’s market risk and shows a stock’s volatility relative to the market
- Indicates how risky a stock is if the stock is held in a well-diversified portfolio
