Assignment Example | Topics and Well Written Essays - 1000 words - 2

Assignment Example The addition of these two variables would then be divided by the original price the investor paid for the stock or lot of stocks. This calculation would give the gross return. The net return is calculated by subtracting the tax expenses associated with the investment from the numerator of the formula. It is important for investors to periodically calculate the return they would achieve if they sold a stock at a particular point in time. This can help investors determine when it is the best moment to sell their stock investment. 2. Contrast systematic and unsystematic risk. There are two types of risks that investors must pay close attention to. The two types of risks are systematic and unsystematic risk. Systematic risk is a risk factor that cannot be control by the investor or the firm due to the fact that it is a market inherent risk. These risk factors affect all firms. Some examples of systematic risks include recessions, wars, inflation, and the occurrence of natural events. In the aftermath of the March 11, 2011 earthquake in Japan the valuation of most Japanese stocks when down a lot. This risk could not have been predicted by an investor. Unsystematic risk is also referred to as firm specific risk or diversifiable risk. Unsystematic risks are risks that can be controlled by the firm. Some examples of these risks include employee strikes, lawsuits, unsuccessful product launches, and the quality of the labor force hired by the firm. A way to offset the effects of unsystematic risks is through diversification. A smart investor is able to reduce the unsystematic risk of their portfolio by purchasing a wide array of investments including blue chip stocks, bonds, and mutual funds. Within the stocks selected by the investor they choose common stocks from firms from different industries. Both systematic and unsystematic risk must be considered by people that are contemplating investing in the stock market. 3. Explain why the total risk of a portfolio is not sim ply equal to the weighted average of the risks of the securities in the portfolio. Many people think because the expected return on a portfolio is calculated as the weighted average of the expected returns of individual stocks that the risk of a portfolio is calculated in the same. Well all those people that thought that way are wrong. Generally speaking the portfolio risk is usually smaller than the weighted average. This occurs because on many instances the risk of different stocks offset each other. A way to measure how the risk of the different stocks of a portfolio is affected is by using the correlation coefficient. The correlation coefficient measures the degree of relationship between two variables. It is possible for a portfolio of two stocks that both have risks to formulate a riskless portfolio if the risks of the two stocks cancel each other out. This can occur because the returns of each stock move in opposite directions. 4. State what beta measures and its uses. The be ta coefficient measures a stock’s sensitivity to fluctuations in the stock market. The normal beta is 1.0. A 1.0 beta implies that the common stock has the same risk as the market. When a company has a beta below 1.0 the common stock of the firm is not affected too much by the market risk. Stocks that have betas above 1.0 are very sensitive to fluctuations in the stock market. A stock that has a beta coefficient of 2.0 implies that the firm is twice as volatile or risky as