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CHAPTER 3 RISK AND RETURN OVERVIEW Risk is an important concept in financial analysis, especially in terms of how it affects security prices and rates of return. Investment risk is associated with the probability of low or negative future returns. The riskiness of an asset can be considered in two ways: (1) on a stand-alone basis, where the asset’s cash flows are analyzed all by themselves, or (2) in a portfolio context, where the cash flows from a number of assets are combined and then the consolidated cash flows are analyzed. In a portfolio context, an asset’s risk can be divided into two components: (1) a diversifiable risk component, which can be diversified away and hence is of little concern to diversified investors, and (2) a market risk component, which reflects the risk of a general stock market decline and which cannot be eliminated by diversification, hence does concern investors. Only market risk is relevant; diversifiable risk is irrelevant to most investors because it can be eliminated. An attempt has been made to quantify market risk with a measure called beta. Beta is a measurement of how a particular firm’s stock returns move relative to overall movements of stock market returns. The Capital Asset Pricing Model (CAPM), using the concept of beta and investors’ aversion to risk, specifies the relationship between market risk and the required rate of return. This relationship can be visualized graphically with the Security Market Line (SML). The slope of the SML can change, or the line can shift upward or downward, in response to changes in risk or required rates of return. OUTLINE With most investments, an individual or business spends money today with the expectation of earning even more money in the future. The concept of return provides investors with a convenient way of expressing the financial performance of an investment. One way of expressing an investment return is in dollar terms. Dollar return = Amount received – Amount invested.