Share Market

We are all familiar with the adage “No Risk, No Return!” However, imprudent investing or investing without sound financial knowledge leads an investor to “All Risk and No Return” situation. Mutual Funds help an investor who does not have expert technical knowledge about the financial market to reap the benefits of excess returns, than risk-free assets, obtained from investing in the financial market. However, mutual funds are not risk free and investors are subject to both systematic and unsystematic risks. According to Adam Smith, investors are rational animals. That is, they do not accept more risk for the sake of it and they’ll do so only if compensated by higher expected return.

The risk a security arises because actual return may turn out to be different from expected return. The expected return is usually estimated from past prices and from additional non-price information (if any). Usually the standard deviation of past returns is used to estimate risk.

A portfolio of securities is a combination of more than one security. Hence a mutual fund can be considered to be a portfolio. The (expected) return on a portfolio of securities is the weighted average of (expected) returns on individual securities. However the risk of a portfolio cannot be computed with the weighted average of standard deviation of individual stocks because the stocks co-vary with each other.

For example, lets consider a mutual fund has investments in 2 securities in the proportion of ‘a’ and ‘b’, whose expected returns are X & Y respectively. Also ?X and ?Y are the risks of stocks 1 & 2. Then the risk of the portfolio can be calculated by

Due to some degree of covariance between any two stocks, the risk of the portfolio is usually less than the weighted average of risks of individual stocks. That means, a portfolio of equities is usually less risky than a single equity. That is, risk can be minimized by including larger and larger number of stocks in the portfolio. Hence diversification reduces risk, helping investors to achieve their return objectives.