Risk, Return & Investment Performance Flashcards

What is the relationship between risk and return in investments?

Answer: Higher risk often leads to higher potential return

In investments, there is generally a positive correlation between risk and return, meaning that assets with a higher potential for significant gains typically also carry a higher potential for losses. Investors seeking greater returns often must accept a higher degree of risk, as lower-risk investments usually offer more modest, but more predictable, returns. This is known as the risk-return trade-off.

What is a common measure of investment risk?

Answer: Standard deviation

Standard deviation is a common statistical measure used to quantify the amount of variation or dispersion of a set of data values. In finance, it measures the historical volatility of an investment, indicating how much the asset's returns have deviated from its average return. Thus, it serves as a key indicator of an investment's risk.

What does the Sharpe ratio measure?

Answer: Risk-adjusted return

The Sharpe ratio is a widely used metric in finance that measures the performance of an investment by adjusting for its risk. It calculates the excess return (return above the risk-free rate) per unit of total risk (standard deviation). A higher Sharpe ratio indicates better risk-adjusted performance, allowing investors to compare the efficiency of different assets or portfolios.

What is the purpose of diversifying a portfolio?

Answer: To reduce overall risk

Diversifying a portfolio involves investing in a variety of assets across different asset classes, industries, and geographies. The primary purpose of this strategy is to reduce overall portfolio risk by ensuring that poor performance in one investment is offset by better performance in others. This helps to smooth out returns and protect against significant losses.

What is the risk-free rate of return?

Answer: The return on government bonds

The risk-free rate of return is a theoretical rate of return on an investment with zero risk, meaning there is no chance of financial loss. In practice, this is often approximated by the return on short-term government bonds, such as U.S. Treasury bills. These are considered to have the lowest credit risk due to the backing of the government.

What is the importance of calculating investment performance?

Answer: To assess whether an investment strategy is effective

Calculating investment performance is crucial for evaluating the success and effectiveness of an investment strategy or portfolio. It allows investors to compare actual returns against their financial goals and benchmarks, identify areas for improvement, and make informed decisions about adjusting their asset allocation or investment choices. This assessment helps optimize future outcomes and ensure strategies remain aligned with objectives.

What is a key limitation of using past performance to predict future returns?

Answer: Past performance can be misleading due to changing market conditions

A key limitation of relying on past performance to predict future returns is that market conditions are constantly evolving. Economic cycles, geopolitical events, technological advancements, and shifts in investor sentiment can all impact asset prices in unpredictable ways. This means that historical trends do not guarantee similar future outcomes, making past performance an imperfect predictor.

What does the term 'market volatility' refer to?

Answer: The rate of increase or decrease in asset prices

Market volatility refers to the degree of variation of a trading price series over time. It quantifies how rapidly and significantly asset prices fluctuate, indicating the level of uncertainty or risk associated with an investment. High volatility means prices can change dramatically in either direction, while low volatility suggests more stable price movements.

What is a key factor in determining a portfolio’s risk?

Answer: The relationship between asset prices and returns

A key factor in determining a portfolio's risk is the volatility of its underlying assets, which is directly related to the fluctuations in their prices and the resulting returns. Understanding how individual asset prices move, both independently and in relation to each other, helps assess the overall risk exposure and potential for losses or gains within the portfolio. This relationship is fundamental to risk assessment.