Understanding Investment Risk

Study Notes

Risk is the chance of loss, also known as the possibility of loss or uncertainty.
Risk can be defined as the dispersion of actual results from expected results.
Risk implies the possibility of achieving different returns.
Risk means investors can face multiple scenarios leading to different returns, expressed as probability distributions.
Risk can be defined as the possibility of a negative deviation from desired, expected, or hoped-for returns.
There are two trends in the concept of risk: the first limited to negative deviation from expected returns, and the second encompassing both positive and negative deviations.

Investors seek compensation for the risk associated with investments, meaning higher risks demand higher return rates.
The relationship between return and risk varies depending on investor attitudes towards risk.
Investors are classified into three categories:
- Risk-averse investors are unwilling to pay more than or equal to the expected return.
- Risk-neutral investors are willing to pay equal to the expected return.
- Risk-takers are willing to pay more than the expected return.

Total risk can be divided into two categories based on the potential for reduction through diversification:
- Systematic risk is general, market, or non-diversifiable risk, impacting the entire market due to factors like fiscal and monetary policies, interest rates, exchange rates, and business cycles.
- Unsystematic risk is specific, company, or diversifiable risk, affecting individual companies or sectors due to factors like financial leverage, operating leverage, marketing strategies, and worker strikes.

The relationship between risk and return is a fundamental concept in finance, demonstrating a positive correlation. This means that higher risk generally corresponds to higher potential returns.
While greater risk may offer greater potential returns, there's no guarantee of higher returns. Higher risk also implies the possibility of larger capital losses.
There's a positive correlation between the level of risk and the potential for return.
Lower-risk investments typically have lower potential profits, while higher-risk investments have higher potential profits but also greater loss potential.
Models, like the Capital Asset Pricing Model (CAPM), analyze the relationship between risk and return, focusing on systematic risk and its connection to the required rate of return. CAPM does not use total risk in its calculations.

The Capital Market Line analyzes the relationship between return and risk by describing the relationship between expected return and the standard deviation of expected return.