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    FAQ for small investors

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    1. Risk is a potential for the unexpected to occur. In the business community there are numerous types of risk, which can have an impact on the Cost of Capital.
    2. Concepts that should be understood: risk, Cost of Capital, CGM and CAPM models and the Market Premium Risk.
    3. The models are mathematical presentations on solving for the Price of a stock, or the required rate of return.
    4. In the DB question, consider these thoughts as you respond: (a) in the stock market a no win for the small investor and only the institutional investor can win, and (b) what is your firm's position on risk. Be specific.

    You work for an large investment firm and recently wrote a position article on your firm's approach to investing for the small investor, titled "Investing is for the little guy". The article now appears on your company's website. It has, interestingly enough, generated e-mailed responses from potential clients and your firm is asking you to address some of their questions for a Frequently Asked Questions (FAQ) segment that will be posted to the site soon.

    Specifically, some of the respondents have compared investing in the stock market as a no win situation and only the institutional investors can win. These respondents would like a response that further clarifies your firm's position regarding risk in light of these type of statements.

    In your response, your company has asked that you address these questions building upon the risk-return concepts you identified in the position piece you wrote for the firm.

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    FAQ for small investors

    What is Cost of capital

    The WACC is simply the cost of the several types of capital (called capital components) used by a firm, weighted by their proportions in the firm's capital structure. In order to calculate the WACC, the analyst has to estimate
    the cost of debt
    the cost of preferred stock, and
    The cost of common stock
    In non-profit organizations or government agencies, the WACC may consist of the costs of the different types of debt in the capital structure, including fixed rate debt, variable rate debt and grant anticipation notes.

    What is return?
    Return is income earned on the investments. In stocks income is earned either by way of dividend or capital gain.

    What is risk?

    Risk is the uncertainty that you may not earn your expected return on your investments. For example, you may expect to earn 20% on your stock mutual fund every year. But your actual rate of return may be much lower.

    For example, the S&P 500 index averaged yearly gains of about 20% for the five years that ended in 1999. In 2000, however, the index declined more than 9%. Bonds, meanwhile, performed better than stocks for the first since 1994.

    What is risk -return trade off?
    The risk-return trade-off requires that you accept more risk in exchange for the chance to earn a higher rate of return. If unwilling, you should expect to earn a lower return. Conservative investors, for example, are less willing to lose 10% of their investments in exchange for the chance to earn a higher rate of return. Aggressive investors, on the other hand, are willing to accept this risk in exchange for the chance to earn higher returns
    Rate of return: An investor who is unwilling to accept a higher degree of investment risk in exchange for a chance to earn a higher rate of return. Investment risk is the volatility of investment returns. A basic investing principle states that a higher degree of investment risk is required to earn a potential higher rate of return

    What are different types of risk?
    Major types of risk include:
    Investment risk. Investment risk is the chance that your investment value will fall. Standard deviation is commonly used to measure investment risk. It shows a stock or bond's volatility, or the tendency of its price to move up and down from its average. As standard deviation increases, so does investment risk.
    Market risk. Market risk is the chance that the entire market where your investment trades will fall in value. Market risk cannot be diversified. ll securities are exposed to market risk including recessions, wars, structural changes in the economy, tax law changes, even changes in consumer preferences. Market risk is sometimes used synonymously with systematic risk.
    Interest rate risk. Interest rate risk is the chance that interest rates will change while you hold an investment. Higher rates result in lower returns on stocks and bonds, but higher returns on interest-paying investments.

    Inflation risk. Bonds are especially vulnerable to inflation risk. This is because a bond's coupon payment is usually a fixed amount. When inflation rises, the present value of the coupon falls. Stocks have less risk since dividends can be adjusted for inflation.

    Industry risk. Industry risk is the chance that a set of factors particular to an industry group drags down the industry's overall investment performance. For example, cold weather might adversely affect the retail industry. Or a cutback in capital spending might adversely affect the information technology industry.
    Regulation Risk

    Some investments can be relatively attractive to other investments because of certain regulations or tax laws that give them an advantage of some kind. Municipal bonds, for example pay interest that is exempt from local, state and federal taxation

    Credit risk. Credit risk is the chance that the company selling ...

    Solution Summary

    This provides FAQ for small investors