Tag: risk
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Mean-variance optimization
According to modern portfolio theory, investors are concerned about the “mean” and “variance” of asset returns, where the former captures the “centrality” and the latter the “spread” (or “riskiness”) of potential returns. As such, investors engage in mean-variance optimization. That is, they seek the portfolios that offer the best tradeoff between risk and return. In…
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Idiosyncratic risk
Idiosyncratic risk is the type of risk that affects either a single security such as a stock or a small group of securities. This is in contrast to systematic risk, which affects all risky securities in a particular market. The word “idiosyncratic” is not commonly used in daily language. ln fact, idiosyncratic risk is often…
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What is risk premium?
Risk premium definition The risk premium for a security (e.g., stock, bond, etc.) can be defined as the return the security generates over the risk-free rate of return. For example, if the yields on government bonds are 3%, and a stock is expected to return 8%, then this stock’s risk premium is 8% − 3% =…
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Risk preferences: What’s the opposite of risk averse?
in investmentsAs humans, we have a natural tendency to avoid taking risks when we can, a notion that we refer to as risk aversion. Specifically, when faced with a choice between a safe payoff and a risky one, we’d opt for the latter only if it entails a sufficient risk premium, which is our reward for…
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Fair game meaning
In daily language, “fair game” can be used to suggest that something or someone can be an object of criticism (perhaps because of their behavior or nature). But, what about the meaning of fair game in an economic or financial context? In such a context, a fair game can be defined as a game in…
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Risk appetite definition
in investmentsIt is clear that some people are more comfortable investing in risky stocks than others. In a similar vein, some firms carry significantly more operational risks and/or financial risks than their competitors. Therefore, the appetite for risk varies across both firms and individuals. Generally speaking, an individual’s or an organization’s risk appetite can be defined…
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What is the risk-free rate?
The risk-free rate is the rate of return earned on a risk-free asset. While returns on risky assets such as stocks are uncertain, the key distinction of the risk-free rate of return is that we know its exact value at the time of investment. For example, we may expect a stock to yield 8% over…
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Return volatility formula and calculator
The topic of this lesson is the return volatility of risky assets such as stocks, mutual funds, etc. We will explain how to measure it and provide a calculator as well. What is (stock) return volatility? Imagine an investor who bought shares of a stock three years ago. According to the investor’s calculations, her annual…
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Risk aversion coefficient – meaning and formula
When we discussed investors’ risk preferences, we distinguished between risk-averse, risk-neutral, and risk-seeking behavior. We also explained that risk-averse investors expect compensation for bearing risk, which is called a risk premium. But, how do measure a person’s level of risk aversion? The answer is the risk aversion coefficient. It quantifies the degree to which an…
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Investments quiz – Test your knowledge!
in investmentsThis investments quiz aims to test your knowledge of the material covered in our free investments course. The quiz is a multiple-choice test. It consists of three sections: The solutions are provided at the bottom of this page. Section A: Return calculations 1. You buy a single share of a stock for $10. After three…
