Investment Risk - Research Paper Example

These might include people who either have very small investments or can not afford to diversify; or people who have very strong belief that the stock in which they have concentrated their investments into, will perform as good as they desire. There are many risks to an investment in stocks that an ordinary shareholder has to experience and has to deal with, in order to ensure that his or her investment does not result into a loss. One easiest way to minimize risks is to invest into only those stocks that belong to the companies that are generally called 'blue chips'.

These are the most stable in the market and have little risk of the investment going bad. But, these are also accompanied by a lower rate of return. As a general rule, the higher the risk, the higher the gain, and vice versa. Hence, it is critical for the investor to understand the nature of company he or she is investing into. The risks are required to be kept low but at the same time, the purpose of the investment is to earn profits. This takes us to the discussion around the efficient frontier, which is explained as the optimum portfolio that gives the highest returns while ensuring the security and risk appetite of the investor.

This is called as the optimal portfolio or operating at the efficient frontier. Whenever an investor invests into any stock, he or she takes on two broad kinds of risks, known as systematic risk and non-systematic risk. The systematic risk is due to market conditions like interest rate movements, recession in the economy and other factors that are not in the control of the investors. The non-systematic risk, however, is the one that can be reduced to lower levels using various strategies for risk management including diversification.

Diversification is defined as keeping one's investments into different securities instead of keeping all money in one stock. This is important since different market conditions affect the stock market differently and this affect does not appear on all stocks in the same fashion. Hence, it is possible that an investor faces huge losses by keeping all the investments in specific stocks. Diversification allows the standard deviation around the desired average investment returns to be minimum which is what is desired from the stock investments.

Any portfolio that lies on the efficient frontier has least risk and the most optimal return on the investment. Investors should aim to achieve this efficient frontier in order to reap the maximum benefits with least loss expectancy.Hence, the concepts of portfolio risk, portfolio investment theory and efficient frontier are closely tied together. This framework is called Modern Portfolio