Podcast Beta
Questions and Answers
What is the primary reason the coefficient of variation is used in investment risk analysis?
If the probability distribution of a security is normal, what percentage of the average expected return will lie within ±1 standard deviation?
What is the correct interpretation of the coefficient of variation?
What is the primary difference between systematic and unsystematic risks in a portfolio?
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Which of the following is a correct statement about portfolio risk?
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What is the formula to calculate the coefficient of variation?
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Based on the coefficient of variation, which of the following is a correct conclusion about the risk of FLI and WEB?
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What is the purpose of calculating the standard deviation of an investment?
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What is the relationship between the coefficient of variation and the risk of an investment?
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What is the correct interpretation of the standard deviation of an investment?
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Study Notes
Measuring Risk
- Standard deviation is a measure of volatility, showing how much variation exists from the average return of an investment.
- A smaller standard deviation indicates lower risk, while a higher standard deviation indicates higher risk.
Computing Standard Deviation
- Steps to compute standard deviation:
- Multiply expected individual return by probability distribution.
- Subtract expected average return from the return.
- Square the difference.
- Multiply the squared difference by the probability distribution.
- Square the result.
Example: Timbuktu Corporation
- WEB has a better average expected return of 22% and a higher standard deviation of 16.52%.
- FLI has an average expected return of 14.55% and a standard deviation of 11.80%.
Diversification and Portfolio Risk
- Combining two or more assets in a portfolio helps reduce the standard deviation.
- Minimizing risk also depends on the degree of correlation between the assets in the portfolio.
- Combining two perfectly negatively correlated assets can eliminate the overall portfolio risk.
- Combining two perfectly positively correlated assets does not reduce the risk.
Coefficient of Variation
- The coefficient of variation is a statistical measure of the distribution of data points around the mean.
- It is computed as the ratio of the standard deviation to the mean.
- It is useful for comparing the degree of variation from one data series to another.
- The investment with a higher coefficient of variation is riskier.
Example: FLI and WEB
- FLI has a higher coefficient of variation, making it a riskier asset than WEB.
Portfolio Risk
- Portfolio risk is associated with the total risks of the portfolio, consisting of systematic and unsystematic risks.
- It is not computed by simply obtaining the weighted average of the expected returns of the individual assets in the portfolio.
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Description
Learn how standard deviation measures risk and volatility in investments, and how it indicates the level of risk.
