Understanding stock risk, portfolio beta, and weighted average cost of capital

Components of a stock's realized return are distributions, dividends, bonds, and share price appreciation. Some kinds of stocks also offer income tax write-offs.

The characteristics of a realized return, in short, are the quantity of actual gains that is made on the value of a portfolio over a specific period of time. In other words, how much value one has received in terms of returns / gains as demonstrated in one's portfolio as a whole.

The realized return considers the profitable returns of the each of the assets contained in one's portfolios as well as each of the losses of particular assets incurred during that specific period, as a result of flucturtaitons that occurred to the market of particular assets. These are the components of each of the realized returns associated with each individual asset that is held in the portfolio.

Calculating the rate of return would enable the investor to decide how and how often to diversity his investments and would also inform him regarding the stability of his portfolio. If the rate of return of individuals or particular assets is not as it should be, the investor would be wise to consider making changes in his investments before incurring further losses.

Calculating the realized returns will also tell the investor regarding which assets to hold onto a little longer, which to sell, and when acquiring additional shares would be a wise decision (Wise geek.).

Contrast systematic and unsystematic risk.

Systematic risk refers to the risk that effects the whole stock market and can, consequently not be diversified in any which way or reduced. As per example, international / political complications (such as a recession) will affect the stock market as a whole rather than any single stock, and, in the same way, any change in interest will similarly effect the whole market, though some sectors may be more impacted than others. No amount of diversification can reduce this effect or risk from occurring and, therefore, this situation is called non-diversifiable or systematic risk.

Unsystematic risk, on the other hand, refers to the spectrum and factors of variability in the stock or security return that are reducible to characteristics that are unique to that specific company. The management of the company, for instance, may be poor, or the company workers may often go on strike; there is risk of product recall, or death or dismissal of key personnel and so forth. When one invests in a specific company, one is taking on all the potential risks, and the consequences of those risks that the company may face. This kind of risk can better be averted and dealt with than the first -- and is, therefore, called unsystematic risk, since the situation exists with only one particular company. In this instance, accordingly, one can decide to invest in more than one company -- diversify one's earnings -- and this type of risk is, therefore, called 'diversifiable risk' (Difference between Systematic and Unsystematic Risk)

One is advised to diversify one's investments in this situation since the result of unsystematic risk is that factors detrimental to the company will cause share prices to drop causing investor to potentially have his entire portfolio wiped out.

Explain why the total risk of a portfolio is not simply equal to the weighted average of the risks of the securities in the portfolio.

Although the total risk of a portfolio is obviously contingent on the risks of the individual assets or investments, it is not equal to the weighted average of the risks of securities in the portfolio (I.e. is usually less than the risk of a single asset) due to the circumstances of unpredictability, in other words that the returns of different assets fluctuate -- are up and down depending on the times and at different times.

Different categories of assets also respond differently in varying economic situations. For instance, stocks tend to go down when interest rates rise. This makes it more expensive to borrow money to buy stocks hence lowering the demand for the sticks, hence causing prices to go down. Proportionally, investors, due to higher interest rates, consequently move their money into securities such as bonds that pay interest. Correlations change according to different economic conditions and times and, therefore, the total risk of the portfolio has nothing to do with the weighted average of the risks of individual securities that constitutes the portfolio.

Portfolio risk can be reduced by diversification -- spreading out one's investments in various companies, since diversifiable risk declines and each company experiences fluctuations of profits at different rates and during different times (Portfolios Returns and Risks. http://thismatter.com/money/investments/portfolios.htm)

State what beta measures and its uses.

Beta measures the degree of volatility or systematic risk of a security or portfolio in comparison to the general market as an entity. Also known as the "beta coefficient," beta is the measurement employed by the capital asset pricing model (CAPM) which is a model that calculates the expected return of an asset -- or how much the person will gain from investment in a specific stock or company. The model's algorithm is based on beta and expected market results of that particular asset.

Beta is calculated via regression analysis, i.e. assessing correlation between dependent and independent factors. Fluctuations in the market (see discussion above) are taken into account. Beta, in other words, is an account of the security's reaction to swings and fluctuations in the market. A beta of 1 show that the security is managing to swing or move with motions in the market whilst a beta of less than 1 indicates that the security's return will be less volatile than that of the market. A beta, on the other hand, that exceeds 1 indicates that the securities price will be more volatile than that of the market.

Betas that exceed 1 offer possibility of higher rate of return, but they also pose greater risk (Investopedia.)