“The essential message of portfolio theory is that diversification
reduces risk”
Answer the following questions asked by your potential clients
a) How does diversification reduce risk? The principle of diversification
is that spreading an investment across a number of assets will
eliminate some, but not all, of the risk. Forming portfolios can
eliminate the diversifiable risk or unique risk associated with
individual assets. There is a minimum level of risk that cannot be
eliminated simply by diversifying. This minimum level is labelled
‘non- diversifiable risk’ or systematic risk
b) How do we measure the risk of an individual share? Give examples of
such risk. A beta coefficient tells us how much systematic risk a
particular asset has relative to an average asset. Examples of
Systematic risk are GNP, interest rates and inflation.
c) How do we measure the risk of a well-diversified portfolio? Give
examples of such risk. The risk of a well-diversified portfolio is
measured using a portfolio Beta. Multiple each asset’s beta by its
portfolio weight and then add the results up to get the portfolio’s
beta. . Examples of Systematic risk are GNP, interest rates and
inflation.
d) What risk are investors compensated for? Why? Systematic Risk as
non systematic risk is essentially eliminated by diversification, so
a relatively large portfolio has almost no non- systematic risk
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e) Use the Security Market Line to illustrate the relationship between risk
and return on an individual security and explain how this line may be
used to derive the return required on an individual share.
SML Positively sloped
straight line displaying
the relationship between
expected return and beta
.
1.0 Beta