Chapter 8 Risk and Rates of Return 259investors higher expected returns. Put another way—if you are seeking higher
returns, you must be willing to assume higher risks.- Diversi" cation is crucial. By diversifying wisely, investors can dramatically
reduce risk without reducing their expected returns. Don’t put all of your
money in one or two stocks or in one or two industries. A huge mistake that
many people make is to invest a high percentage of their funds in their employ-
er’s stock. If the company goes bankrupt, they not only lose their job but also
their invested capital. While no stock is completely riskless, you can smooth
out the bumps by holding a well-diversi" ed portfolio. - Real returns are what matters. All investors should understand the difference
between nominal and real returns. When assessing performance, the real return
(what you have left over after in! ation) is what matters. It follows that as
expected in! ation increases, investors need to receive higher nominal returns. - The risk of an investment often depends on how long you plan to hold the
investment. Common stocks, for example, can be extremely risky for short-
term investors. However, over the long haul, the bumps tend to even out; thus,
stocks are less risky when held as part of a long-term portfolio. Indeed, in his
best-selling book Stocks for the Long Run, Jeremy Siegel of the University of
Pennsylvania concludes that “[t]he safest long-term investment for the preser-
vation of purchasing power has clearly been stocks, not bonds.” - While the past gives us insights into the risk and returns on various invest-
ments, there is no guarantee that the future will repeat the past. Stocks that
have performed well in recent years might tumble, while stocks that have
struggled may rebound. The same thing may hold true for the stock market as
a whole. Even Jeremy Siegel, who has preached that stocks have historically
been good long-term investments, also has argued that there is no assurance
that returns in the future will be as strong as they have been in the past. More
importantly, when purchasing a stock, you always need to ask, “Is this stock
fairly valued, or is it currently priced too high?” We discuss this issue more
completely in the next chapter.
SELF^ TEST Explain the following statement: The stand-alone risk of an individual corpo-
rate project may be quite high; but viewed in the context of its e" ect on
stockholders’ risk, the project’s true risk may not be very large.
How does the correlation between returns on a project and returns on the
# rm’s other assets a" ect the project’s risk?
What are some important concepts for individual investors to consider when
evaluating the risk and returns of various investments?In this chapter, we described the relationship between risk and return. We discussed
how to calculate risk and return for individual assets and for portfolios. In particular,
we di! erentiated between stand-alone risk and risk in a portfolio context and we ex-
plained the bene" ts of diversi" cation. We also discussed the CAPM, which describes
how risk should be measured and how risk a! ects rates of return. In the chapters that
follow, we will give you the tools needed to estimate the required rates of return on
T Y I N G I T A L L T O G E T H E R