Question

If an investor holds all of her wealth in a single asset, the most appropriate measure for finding the risk of that asset would be what?

Answer 1

The most appropriate measure for finding the risk of an asset held entirely by an investor is the asset's standard deviation or volatility. High risk can be detrimental, as seen in the 2008 crisis, and investors should expect higher returns to compensate for this increased risk.

Step-by-step explanation:

If an investor holds all of her wealth in a single asset, the most appropriate measure for finding the risk of that asset would be its standard deviation or volatility. These measures provide a quantifiable estimate of the variability in the asset's returns, indicating the level of uncertainty and the potential for a different outcome than the expected return. It's important to note that investors should seek a tradeoff between risk and return, as higher risk levels may offer potential for higher returns but can also lead to more significant losses.

Throughout history, high-risk levels have proven detrimental when market downturns have occurred, as seen during financial crises like the 2008 financial crisis. High-risk investments, such as stocks, need to compensate investors for taking on additional risk by potentially offering a higher average return; otherwise, they would not be attractive compared to lower-risk options like bank accounts or bonds. Therefore, when assessing a single asset's riskiness, it’s crucial to consider how its volatility can impact an investor's entire portfolio. In cases of significant market fluctuations, a diversified portfolio typically fares better than one concentrated in a single, volatile asset.

The most appropriate measure for finding the risk of a single asset held by an investor is the standard deviation. Standard deviation is a statistical measure that calculates the volatility or variability of returns from an investment. It provides a measure of how much the returns on the asset are likely to deviate from the average return. For example, if an investor holds all of their wealth in a single stock, the standard deviation would help assess the potential range of returns that the stock could generate, indicating the level of the stock's risk.

Answer 2

The standard deviation of returns is the most suitable measure for understanding the risk of a single asset in an investor's portfolio, evaluating the variability of possible returns compared to the expected rate of return.

Step-by-step explanation:

The most appropriate measure for finding the risk of a single asset held by an investor is the standard deviation of the asset's returns, which quantifies the variability of the returns around the mean. The expected rate of return can be used to estimate the average gain that the investment is likely to produce over a long period. However, the actual rate of return might significantly differ from the expected return due to the inherent risks. A high-risk investment has a wide range of potential payoffs, meaning its actual returns can vary substantially from the expected returns, potentially leading to greater gains or losses. Investments that do not compensate for higher risk levels with higher potential returns are often deemed less attractive to investors.

When analyzing the risk of investments, one must consider factors such as default risk, which reflects the possibility that the borrower may fail to make the necessary payments, and interest rate risk, which addresses the potential for interest rates to increase after a bond is purchased, leading to missed opportunities for higher returns. Therefore, to understand the risk and potential rewards of an investment, investors need to analyze the expected rate of return alongside the variability and frequency of actual return rates.