Question

Instructions : Complete the following assignment using either MS Word or Google Docs. Handwritten scripts will not be accepted. Approx 1000 words. The rational Investor will expect a return on his/her investment. 1. Explain why a return is expected, what is the expected return compensating the investor for? How does this theory hold up in a time of negative interest rates on government short term bonds? 2. Discuss the impact of combining investments into a portfolio.

Approx 1000 word

Answer 1

What Is Expected Return?

The expected return is the profit or loss an investor anticipates on an investment that has known or anticipated rates of return (RoR). It is calculated by multiplying potential outcomes by the chances of them occurring and then totaling these results. For example, if an investment has a 50% chance of gaining 20% and a 50% chance of losing 10%, the expected return is 5% (50% x 20% + 50% x -10% = 5%).

How Expected Return Works The expected return is a tool used to determine whether an investment has a positive or negative average net outcome. The sum is calculated as the expected value (EV) of an investment given its potential returns in different scenarios, as illustrated by the following formula: Expected Return = SUM (Returni x Probabilityi) where: "i" indicates each known return and its respective probability in the series

The expected return is usually based on historical data and is therefore not guaranteed. This figure is merely a long-term weighted average of historical returns. In the example above, for instance, the 5% expected return may never be realized in the future, as the investment is inherently subject to systematic and unsystematic risks. Systematic risk the danger to a market sector or the entire market whereas unsystematic risk applies to a specific company or industry.

Limitations of Expected Return

It is quite dangerous to make investment decisions based on expected returns alone. Before making any buying decisions, investors should always review the risk characteristics of investment opportunities to determine if the investments align with their portfolio goals.

2. Impact of combaining investment into portfolio.

Diversification is a technique that reduces risk by allocating investments among various financial instruments, industries, and other categories. It aims to maximize returns by investing in different areas that would each react differently to the same event. Most investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimizing risk. Here, we look at why this is true and how to accomplish diversification in your portfolio.

PART OF How to Invest with Confidence INVESTOPEDIA INVESTING The Importance Of Diversification FACEBOOK TWITTER LINKEDIN By NICK K. LIOUDIS Updated Aug 15, 2019 Diversification is a technique that reduces risk by allocating investments among various financial instruments, industries, and other categories. It aims to maximize returns by investing in different areas that would each react differently to the same event. Most investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimizing risk. Here, we look at why this is true and how to accomplish diversification in your portfolio. KEY TAKEAWAYS Diversification reduces risk by investing in investments that span different financial instruments, industries, and other categories. Risk can be both undiversifiable or systemic, and diversifiable or unsystemic. Investors may find balancing a diversified portfolio complicated and expensive, and it may come with lower rewards because the risk is mitigated. Different Types of Risk Investors confront two main types of risk when investing. The first is undiversifiable, which is also known as systematic or market risk. This type of risk is associated with every company. Common causes include inflation rates, exchange rates, political instability, war, and interest rates. This type of risk is not specific to a particular company or industry, and it cannot be eliminated or reduced through diversification—it is just a risk investors must accept.

Why You Should Diversify Let's say you have a portfolio of only airline stocks. If it is announced that airline pilots are going on an indefinite strike and that all flights are canceled, share prices of airline stocks will drop. That means your portfolio will experience a noticeable drop in value.

Problems with Diversification While there are many benefits to diversification, there may be some downsides as well. It may be somewhat cumbersome to manage a diverse portfolio, especially if you have multiple holdings and investments. Secondly, it can put a dent in your bottom line. Not all investment vehicles cost the same, so buying and selling may be expensive—from transaction fees to brokerage charges. And since higher risk comes with higher rewards, you may end up limiting what you come out with. There are also additional types of diversification, and many synthetic investment products have been created to accommodate investors' risk tolerance levels. However, these products can be very complicated and are not meant to be created by beginner or small investors. For those who have less investment experience, and do not have the financial backing to enter into hedging activities, bonds are the most popular way to diversify against the stock market. Unfortunately, even the best analysis of a company and its financial statements cannot guarantee it won't be a losing investment. Diversification won't prevent a loss, but it can reduce the impact of fraud and bad information on your portfolio.