Risk and return, Analysis and Investment

What is “risk and return”?
In investing, there is a close correlation between risk and return. Usually, increased potential returns on investment go hand in hand with increased risks. The different types of risks include project-specific risk, industry-specific risk, competitive risk, international risk, and market risk. Yield refers to the gains and losses resulting from trading a security.
The return on investment is expressed as a percentage and is considered a random variable that takes any value within a certain range. There are several factors that influence the type of returns that investors can expect from trading the markets.
Diversification allows investors to reduce the overall risk associated with their investment portfolios but may limit potential returns. Investing in just one market segment, if that segment significantly outperforms the market as a whole, may yield higher returns, but if the segment declines, you may experience returns lower than would have been achieved with a broadly diversified portfolio.

Risk and return
How does diversification reduce or eliminate risk for a company?
First, each investment in a diversified portfolio represents only a small percentage of that portfolio. Thus, any risk that increases or decreases the value of that particular investment or group of investments will have little impact on the overall portfolio.

Second, the effects of a company’s own actions on the prices of individual assets in the portfolio can be either positive or negative for each asset in any period. Thus, in large portfolios, it can reasonably be said that positive and negative factors will vanish so as not to affect the overall risk level of the aggregate portfolio.
The benefits of diversification can also be shown mathematically:
σ^2 portfolio = WA^2σA^2 + WB^2σB^2 + 2WA WBр ABσ AσB
σ = standard deviation
W = weight of investment
a = origin a
b = origin b
р = covariance
Other things being equal, the higher the correlation in returns between two assets, the lower the potential benefits from diversification.
Comparative analysis of risk and return models
Capital Asset Pricing Model (CAPM)
multifactorial model
proxy models
Accounting and debt-based models
For investments that involve equity risk, the best measure of risk is to look at the variance of actual returns around the expected return. In CAPM, exposure to market risk is measured with a beta in the market. The APM and multifactor models allow examination of multiple sources of market risk and the estimation of investment beta for each source. A regression or proxy model looks for company characteristics, such as size, that have been associated with high returns in the past and uses them to measure market risk.
For investments with a default risk, the risk is measured by the probability that the promised cash flows will not be delivered. Investments with higher default risk usually charge higher interest rates, and the premium we charge over the no-risk rate is called the default premium. Even in the absence of ratings, interest rates will include a default premium that reflects lenders’ assessments of default risk. The risk-adjusted default interest rates represent the company’s borrowing or debt cost.
Related readings
Investing: A Beginner’s Guide
market risk premium
Basic RISK
Expected return
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