230 Part 3 Financial Assets
We start this chapter from the basic premise that investors like returns and dislike
risk; hence, they will invest in risky assets only if those assets o! er higher expected
returns. We de" ne what risk means as it relates to investments, examine procedures
that are used to measure risk, and discuss the relationship between risk and return.
Investors should understand these concepts, as should corporate managers as they
develop the plans that will shape their " rms’ futures.
Risk can be measured in di! erent ways, and di! erent conclusions about an
asset’s riskiness can be reached depending on the measure used. Risk analysis can be
confusing, but it will help if you keep the following points in mind:- All business assets are expected to produce cash fl ows, and the riskiness of an
asset is based on the riskiness of its cash # ows. The riskier the cash # ows, the risk-
ier the asset. - Assets can be categorized as fi nancial assets, especially stocks and bonds, and as
real assets, such as trucks, machines, and whole businesses. In theory, risk analysis
for all types of assets is similar and the same fundamental concepts apply to all
assets. However, in practice, di! erences in the types of available data lead to dif-
ferent procedures for stocks, bonds, and real assets. Our focus in this chapter is on
" nancial assets, especially stocks. We considered bonds in Chapter 7; and we take
up real assets in the capital budgeting chapters, especially Chapter 12. - A stock’s risk can be considered in two ways: (a) on a stand-alone, or single-stock,
basis, or (b) in a portfolio context, where a number of stocks are combined and
their consolidated cash # ows are analyzed.^1 There is an important di! erence
between stand-alone and portfolio risk, and a stock that has a great deal of risk
held by itself may be much less risky when held as part of a larger portfolio. - In a portfolio context, a stock’s risk can be divided into two components: (a) diver-
sifi able risk, which can be diversi" ed away and is thus of little concern to diversi-
" ed investors, and (b) market risk, which re# ects the risk of a general stock market
decline and cannot be eliminated by diversi" cation (hence, does concern inves-
tors). Only market risk is relevant to rational investors because diversi" able risk
can and will be eliminated. - A stock with high market risk must o! er a relatively high expected rate of return
to attract investors. Investors in general are averse to risk, so they will not buy risky
assets unless they are compensated with high expected returns. - If investors, on average, think a stock’s expected return is too low to compensate for
its risk, they will start selling it, driving down its price and boosting its expected
return. Conversely, if the expected return on a stock is more than enough to
Market 4: 2008 and Thereafter: Bull or Bear? In early 2008,
the big question is this: Will the bull market continue; or are
we entering another bear market, with a possible decline of50% or so? We wish we knew! By the time you read this,
you will know; but it will be too late to profit from that
knowledge.(^1) A portfolio is a collection of investment securities. If you owned stock in General Motors, ExxonMobil, and IBM,
you would be holding a three-stock portfolio. Because diversi! cation lowers risk without sacri! cing much if any
expected return, most stocks are held in portfolios.
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