Discuss what distinguishes a stand-alone risk from a portfolio risk. Explain the expected rate of return and probability.

Answer 1

A stand-alone risk is a risk that affects a single investment or asset, while a portfolio risk refers to the overall risk of a collection of investments, such as a diversified investment portfolio.

The expected rate of return is the anticipated rate of return that an investor expects to earn on an investment, while probability refers to the likelihood of a particular event occurring.

In terms of stand-alone risk, the expected rate of return and probability are closely related. A high expected rate of return generally means that the investment has a higher risk and volatility, making it more likely that the investment will experience large fluctuations in value. The probability of achieving a high return is usually lower for high-risk investments. Conversely, low-risk investments generally offer lower returns but are less likely to experience large fluctuations in value. In this case, the probability of achieving a lower return is usually higher.

In portfolio risk, the relationship between expected return and probability is more complex. The expected rate of return is determined by the overall performance of the portfolio, which takes into account the individual returns and risks of each investment in the portfolio. While individual investments may have high or low expected returns and probabilities, the overall expected return and probability of the portfolio will depend on the specific weights and correlations of the individual investments. Diversification can help to reduce portfolio risk by spreading investments across different asset classes, sectors, and regions to reduce concentration risk and increase the likelihood of achieving a more stable and consistent return.