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Which of the following investments has the greater relative risk? Investment Expected Return...

Question:

Which of the following investments has the greater relative risk?

Investment Expected Return Standard Deviation
F 16% 7%
G 27% 13%

Risk and Return Tradeoff:

This question requires a general understanding of a basic investment theory focused on the tradeoff between risk and reward. Essentially, to achieve a higher return, and investor must assume greater risk. Risk can be defined in many ways, but traditionally, risk has been defined as the volatility of an asset's annual return, as measured by the standard deviation of returns.

Answer and Explanation:

At a glance, Investment G appears riskier, because it exhibits the higher standard deviation. However, to appropriately answer this question, we must holistically look at each investment's risk/return profile. To do so, we should evaluate the efficiency of each investment - the return offered per unit of risk. A simple way to do this is to divide the expected return by the standard deviation. The higher the number, the better.

The computations and synopsis are below.

Investment F Efficiency = .16 / .07 = 2.29

Investment G Efficiency = .27 / .13 = 2.08

Investment F is the more efficient of the 2. Therefore, Investment G has the greater relative risk.


Learn more about this topic:

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Investment Risks: Definition & Types

from Finance 305: Risk Management

Chapter 3 / Lesson 3
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