Risk and return are basic characteristics of any investment as financial assets are generally defined on their basis. A comparison along these two dimensions simplifies the process of selecting from millions of assets and makes financial assets substitutable. These characteristics distinguish financial assets from physical ones, which can be defined along multiple dimensions. Although financial assets are generally claims on real assets, their commonality across the two dimensions, namely risk and return, simplifies the issue and makes them easier to value than real assets.
Risk aversion and portfolio selection
Equity shares, bonds and treasury bills provide different levels of returns and have different levels of risk. Although investment in equities may be appropriate for one investor, another may not be inclined to accept the risk that accompanies a share of a company and prefer to hold more cash. The concept of risk aversion is related to the behaviour of investors under uncertainty.
Assume that an individual is offered two alternatives: (a) one where he will get Rs 500 for sure and (b) the other one is with a 50% chance that he gets Rs 100 and 50% chance he gets nothing. The expected value in both cases is Rs 50, one with certainty and the other with uncertainty. What will an investor choose There are three possibilities: an investor goes for the gamble, chooses Rs 50 with certainty, or he is indifferent. An investor is said to be risk-seeking if he choses the option b. He is considered risk averse if he chose option a and termed as risk-neural if he is indifferent. In general, investors are likely to shy away from risky investments for a lower, but guaranteed return. That is why they want to minimise their risk for the same amount of return, and maximise their return for the same amount of risk. A risk-neutral investor would maximise return, irrespective of risk, and a risk-seeking investor would maximise both risk and return.
Diversification will not always help
Diversification is one of the most important and powerful concepts in investment science. As investors are risk averse, they are interested in reducing risk, preferably without reducing return. In other cases, investors may accept a lower return if it will reduce the chance of catastrophic losses. Correlation is the key in diversification of risk. Lower correlations are associated with lower risk. In reality, most assets have high positive correlations. But diversifying the portfolio by picking up uncorrelated shares or assets of different types may not always work. This is a myth in the minds of many investors. Low or negative correlation can help, but that is not always the case. Using a single variable, such as correlation, can lead to problems in portfolio construction if you dont use some discretion.
To conclude, the perfect and optimal portfolio is still the one that you can stick with based on your personal circumstances, risk tolerance and time horizon, not the one you create using fancy statistical formulae.
The writer is associate professor of finance & accounting at IIM Shillong