1. Is risk aversion a reasonable assumption? What is the relevant measure of risk for a risk averse investor?
2. What are the benefits of diversification to an investor? what is the key factor determing the extent of these benefits?
3. Total risk can be decomposed into systematic risk. Explain each component of risk, and how each is affected by increasing the number of securities in a portfolio.
Here are your answers:
Describes an investor who, when faced with two investments with a similar expected return (but different risks), will prefer the one with the lower risk.
Risk aversion is a concept in economics, finance, and psychology explaining the behaviour of consumers and investors under uncertainty. Risk aversion is the reluctance of a person to accept a bargain with an uncertain payoff rather than another bargain with a more certain but possibly lower expected payoff. The inverse of a person's risk aversion is sometimes called their risk tolerance. For a more general discussion see the main article risk.
A person is given the choice between a bet of either receiving $100 or nothing, both with a probability of 50%, or instead, a certain (100% probability) payment. Now he is risk averse if he would rather accept a payoff of less than $50 (for example, $40) with probability 100% than the bet, risk neutral if he was indifferent between the bet and a certain $50 payment, risk-loving (risk-proclive) if it required that the payment be more than $50 (for example, $60) to induce him to take the certain option over the bet.
The average payoff of the bet, the expected value would be $50. The certain amount accepted instead of the bet is called the certainty equivalent, the difference between it and the expected value is called the risk premium.
Benefits of diversification & Key Factors:
How many times have you heard someone say, "Don't put all your eggs in one basket"? When it comes to investing, that's very good advice.
Successful investors know that diversifying their investments can help reduce the impact that a single, poorly performing investment can make on their overall portfolio, or mix of investments.
Diversification means having different kinds of investments, such as stocks, bonds, and mutual funds. It also means having a mix of investments in different sectors or industries. A well-diversified portfolio might include bonds, money market funds, and stocks of small, medium, and large companies in a variety of industries and countries. International stocks, for example, may rise at the same time domestic stocks are falling, softening the blow to your overall portfolio. Even if your risk tolerance is low, you can still consider ...