Retirement Investment Products

In finance, we define risk as the chance that you will notreceive the return that you expect, regardless of whether theactual outcome is better than expected or worse than expected.

Riskier investments, mush have expected returns than less riskyinvestments, otherwise, people will not purchase investments withhigher risks.

The total risk of any investment can be divided into twocomponents: diversifiable risk and nondiversifiable risk.Diversifiable risk is not important to informed investors becausethey will eliminate its effects through diversification. Thus, therelevant risk is nondiversifiable risk because it cannot beeliminated, even in a perfectly diversified portfolio.

The effects of nondiversifiable risk, which is also designatedsystematic risk or market risk, can be determined by computing thebeta coefficient of an investment. The beta coefficient measuresthe volatility of an investment relative to the volatility of themarket, which is considered to be nearly perfectly diversified andthus is affected only by systematic risk.

When the return that investors expect , r^, is lower than thereturn that they require (demand) for similar risk investments, r,they do not purchase the investment, which causes its price todecline and its expected return to increase until r^=r. Whenr^>r, investors buy the investment, which increases its priceuntil r^=r.

Risks that are relevant include those types that are related toeconomic factors, such as interest rate risk, inflation risk, andso forth; risks that are not relevant because they can bediversified away include those types are related to a specific firmor industry, such as business risk, default risk, and so forth.

When investing, first remember, that risk and return arepositively related. As a result, in most cases, when you offered aninvestment that promises to pay a high return, you should concludethat the investment has high risk. When considering possibleinvestments, never seperate “risk” and “return” – that is, do notconsider the return of an investment without also considering itsrisk. Second, remember that, you can reduce some investment riskthrough diversification, which can be achieved by purchasingdifferent investments that are not hightly positively related toeach other. In many instances, you can reduce risk without reducingthe expected rate of return associated with your investmentposition.

Many investors examine the past performance of an investment todetermine its expected return. Care must be taken with its approachbecause past returns often do not reflect future returns. Even so,you might be able to get a rough idea as to what you expect astock’s long-term growth to be in the future by examining its pastgrowth, especially if the firm is fairly stable. Investors alsorely on information provided by professional analysts to formopinions about expected rates of return.

To determine an investment’s required rate of return, investorsoften evaluate the performances of similar-risk investments. Inaddition, some investors use the CAPM to get a “ballpark figure”for an investment’s required rate of return. The beta coefficientsfor most large companies can be obtained from many sources,including the internet; the risk-free rate of return can beestimated using the rates on existing Treasury Securities; and theexpected market return can be estimated by evaluating marketreturns in recent years, the current trend in the market, andpredictions made by economists and investment analysts.

When investing your money, keep these words of wisdom in mind:”if you lose sleep over your investments or are some concerned withthe performance of your portfolio than with your job performance,then your investment position probably is too risky.”