Question

Studying possible essay questions for a future exam: Please answer in a few sentences to a paragraph.

How does risk aversion impact the required rate of return?

Which risk(s) are investors traditionally compensated for if the markets are in equilibrium?

If you are an undiversified investor, with a higher than average level of risk aversion, are you systematically over-paying for your investments, and why?

Answer 1

In a market riskier security is rewarded by higher returns. An investor investing in riskier security expects higher level of returns ( a premium for taking risk). A risk averse investor expects the lower expected rate of return.

We can break the market risk in two categories, systematic and unsystematic risk. Unsystematic risk can be eliminated by portfolio diversification and therefore is not compensated by the market. Example are currency risk, concentration risk. Unsystematic risk can be segment or company specific and can be avoided.

Systematic risks are undiversifiable such as change in interest rates in future, inflation etc. These risk impact the all the securities in the market therefore can not be avoided.

As an undiversified investor you are taking additional risk for unsystematic risk for which market doesn't pay any returns. With the same level of risk and well diversified portfolio expected returns will be higher. The lost opportunity of undiversified portfolio is a cost to the investor.