RESPOND IN 300 WORDS:
When looking at the expected rate of return, “the amount of profit or loss an investor can anticipate receiving on an investment” (Chen, Aug, 2021). An expected return is computed by multiplying possible possibilities by the probability of them occurring, then adding the results together. When dealing with expected rate of returns nothing is guaranteed. When investors create a portfolio that has multiple investments, then it is weighted average for the expected returns. When calculating expected return, the most well-known models modem portfolio theory (MPT) or the Black-Scholes model.
The required rate of return is that “return an investor thinks to receive at least, this is the least minimum return an investor wants to receive” (Cfi, 2021). The required rate is calculated using one of these models. CAPM or the Gordon growth model. The required rate can be estimated by using multiplication and addition. To calculate, multiply the beta and the current market premium and then add the risk-free rate.
Diversification is the process of spreading your risk across many different types of investments with the main purpose of increasing the investor’s chances of financial success. In terms of risk, some of the downsides of a well-diversified portfolio includes lower-than-average returns, a limited potential gain, and the chance for subpar performance if the stock selection is not rigorous.
There are advantages to having a diversified portfolio, some listed below;
- “Minimizes the risk of loss to your portfolio “ (Hicks, Sept, 2019).
- Show the investor more opportunities for return
- Protect against adverse market cycles
- Reduces the volatility
The disadvantages to having a diversified portfolio
- Reduces quality
- Very complicated
- Indexing “when you have to many assets in your portfolio it becomes an index fund” (Faulkenberry, 2021).
- Market risk
- Below average returns
- Lack of focus and attention to your portfolio
When doing any kind of investments there is going to be a certain level
of risk. So, in conclusion, a good and sure thing for any investor to do is to consider pursuing a more limited balance between risk and return, with the primary focus on selecting high-quality investments and determining the correct diversification measure for themselves based on their assets and risk level. Every investor knows investing is a risk and if they have done their research, they will understand the advantages and disadvantages. To include no investment is a sure winner.
RESPOND IN 300 WORDS:
According to the textbook, the expected rate of return represents the average payoff that investors will receive in the future if the probability distributions do not change over a long period of time. (Besley S. 2016).
For example, if an investment has a 50% chance of gaining 30% and a 50% chance of losing 15%, the expected return would be 7.5% = (50% x 30%) + (50% x -15%) (Chen, 2021)
Before making any investment decisions, one should review the risk-return tradeoff to determine if the investments align with their portfolio goals. The risk-return tradeoff states that the potential return rises with an increase in risk. Using this principle, individuals associate low levels of uncertainty with low potential returns, and high levels of uncertainty or risk with high potential returns. The required rate of return (RRR) can help an investor understand if their investment strategy yields the returns they expect. When the required rate of return of an investment needs to be estimated, there are two approaches to estimating: 1) dividends, and 2) the Capital Asset Pricing Model. (Chen, 2021)
Dividend Method: RRR = (Expected dividend payment / Share Price) + Forecasted dividend growth rate.
A company is expected to pay an annual dividend of $3 next year, and its stock is currently trading at $100 a share. The company has been steadily raising its dividend each year at a 4% growth rate. (Murphy, 2021)
RRR = 7% = (($3 expected dividend / $100 per share) + 4% growth rate)
Alternatively, the Capital Asset Pricing Model (CAPM) formula = RRR = Risk-free rate of return + Beta X (Market rate of return – Risk-free rate of return). (Murphy, 2021) The steps involved are:
- Subtract the risk-free rate of return from the market rate of return.
- Multiply the above figure by the beta of the security.
- Add this result to the risk-free rate to determine the required rate of return.
One main advantage of a well-diversified portfolio is that it helps manage risk. There is a lower probability that all investments in the portfolio would do poorly over a period. This means that in a volatile market, a well-diversified portfolio should perform better (or not as badly) as a highly focused investment. Additionally, with a well-diversified portfolio, dividend income may help offset share performance risk. However, one disadvantage is that a well-diversified portfolio could reduce the expected rate of return compared to single investments.
Despite the potentially complex nature of investing, people may be risk averse to the concept. However, an analytical approach can show that most investments have a positive expected rate of return over time, provided they hold onto the assets in a well-diversified portfolio. In the absence of stock price returns, investors can also look towards dividend income, set to a require rate of return they calculate to help provide income.
Besley S., & Brigham E. (2016). CFIN. [South University]. Retrieved from https://digitalbookshelf.southuniversity.edu/#/books/9781305888036/
Chen, J. (2021, August 29). Investing Essentials. Retrieved from Investopedia: https://www.investopedia.com/terms/e/expectedreturn.asp
Murphy, C. B. (2021, October 18). Fundamental Analysis. Retrieved from Investopedia: https://www.investopedia.com/terms/r/requiredrateofreturn.asp