Page 75 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes Figure 4.2: Risk Return Relationship of Different Stocks

Rate of
Return Risk Market Line E(r)
Premium

Ordinary shares
Preference shares
Subordinate loan stock
Unsecured loan
Debenture with floating charge
Mortgage loan
Government stock (risk -free)

O Degree of Risk

The common question arises: who wants to earn 6% when index funds average 12% per year
over the long run? The answer to this is that even the entire market (represented by the index
fund) carries risk. The return on index funds is not 12% every year, but rather 5% one year, 25%
the next year, and so on. An investor still faces substantially greater risk and volatility to receive
an overall return that is higher than a predictable government security. We call this additional
return the risk premium, which in this case is 8% (12% - 8%).
Determining what risk level is most appropriate for you isn't an easy question to answer. Risk
tolerance differs from person to person. Your decision will depend on your goals, income and
personal situation, among other factors.

Self Assessment

Fill in the blanks:

7. Risk and ……………. are two key determinants of an investment decision.
8. Risk is measured by any one of the measures of …………… .
9. Rate of return expected by the investor consists of yield and ……………. .

4.6 Portfolio and Security Returns

A portfolio is a collection of securities. Since it is rarely desirable to invest the entire funds of an
individual or an institution in a single security, it is essential that every security be viewed in a
portfolio context. Thus, it seems logical that the expected return of a portfolio should depend on
the expected return of each of the security contained in the portfolio. It also seems logical that
the amounts invested in each security should be important. Indeed, this is the case. The example
of a portfolio with three securities shown in following table illustrates this point.

The expected holding period value-relative for the portfolio is clearly shown:
= 1.155
Giving an expected holding period return of 15.50%.

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