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Dealing with Risk and Return Trade-Off

Hi, I need some assistance responding to the following questions:

- Why are investors risk-averse? How can investors deal with different degrees of risk?
- What is the expected return on a portfolio? How can the expected return on a portfolio be manipulated to minimize the risk on that portfolio?
- What is the beta coefficient for a firm? What does it tell us about the firm? Why do similar firms have different beta coefficients?

Solution Preview

Investors like to be averse to risk. It causes changes in the stocks' prices, which will in turn cause changes in the expected returns. Consider two firms, Dillards' and JC Penney's stocks. Suppose each stock sold for $150 per share and each had an expected rate of return of 12% with Dillards' standard deviation of 3.87% and JC Penney's standard deviation is 65.84%. Investors are averse to risk, so under those conditions there would be a general preference for Dillards. This makes the bids for Dillards increase, making JC Penney's stockholders start selling their stock and using the money to buy Dillards'. Buying pressure would drive up Dillards' stock, and selling pressure would simultaneously cause JC Penney's price to decline (Brigham & Houston, 2007). The price changes would cause changes in the expected returns of the two securities. When you purchase a stock at a lower price and the expected future cash flows stay the same, then your expected return would be higher.

How can investors deal with different degrees of risk?

Investors deal with different degrees of risk by putting their assets in a portfolio. The portfolio's risk is generally smaller than the average of the individual assets' standard deviation. Individual asset's risk is measured using standard deviation. The reason is, in statistics, the tighter the probability distribution of facts consist of expected future returns, the smaller the risk of that investment. To illustrate, if you are an investor and you invest in two stocks individually with those two stocks having opposite or different rate of return individually as time goes, the two stocks would be quite risky as they are held in isolation. When they are combined to form a portfolio, ...

Solution Summary

This solution explains some fundamental business concepts including investors being risk-averse, different degrees of risk, the expected return on a portfolio, minimizing portfolio risk using expected return, and beta coefficients for firms. The solution is over 1200 words and includes one reference.

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