Risk and Return
Quantify risk with standard deviation, beta, and the Capital Asset Pricing Model. Learn how diversification reduces portfolio risk without sacrificing expected return. This topic connects theoretical finance to practical investing by explaining why investors demand higher returns for taking on more systematic risk.
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Study Tips
- ✓Diversification eliminates firm-specific risk only
- ✓Beta measures sensitivity to market moves
- ✓Risk-free rate anchors every CAPM calculation
- ✓Higher risk does not guarantee higher return
Common Mistakes to Avoid
Confusing total risk (standard deviation) with market risk (beta). Only beta matters in a well-diversified portfolio. Students also frequently use the market return Rm when the formula calls for the market risk premium (Rm - Rf).
Risk and Return FAQs
Common questions about risk and return
The stock moves 1.5 percent for every 1 percent move in the market, on average. A beta above 1 means the stock is more volatile than the market; below 1 means less volatile.
No. It eliminates unsystematic (firm-specific) risk but not systematic (market) risk. Even a perfectly diversified portfolio still faces macroeconomic risks like recessions, interest rate changes, and inflation.
The SML plots expected return against beta for all securities. Stocks above the line are undervalued (offering more return than their risk warrants), and stocks below are overvalued. The SML is the graphical representation of CAPM.
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