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Assignment

Investment Returns and Risk Premiums

Risk comes from not knowing what you are doing.

—Warren Buffett

How do you feel about the following statement: “Avoiding risks is the biggest risk of all”? That statement may seem contradictory at first, but it makes more sense if you apply the concept to various situations in life and business. For example, many people pursue a college degree because they feel it will increase their job prospects and earning potential. This can turn out to be true but is not a guarantee. Others may find this path too risky and prefer to enter the job market right away. Although the first group of people take the risk of their college degree paying off in the long run, the second group are also taking the risk of limiting their potential for the future. Similarly, the nature of entrepreneurship is built upon the risk of investing time and money into something that could potentially fail. Even established businesses could become outdated or be outperformed if they stop taking certain risks. Just as the concept of risk can apply in a general sense, it also applies to investments that individuals and businesses make. Calculated investment risks are not always guaranteed to pay off, but a zero-risk approach may not be as safe as it sounds either.

In this Assignment, you will address questions related to returns and risk premiums.

By Day 7

Submit your responses to the following prompts.

  • Explain the differences between the arithmetic return and the geometric return. Include in your explanation what factor determines the difference between arithmetic returns and geometric (compounded) returns. (75–150 words, or 1–2 paragraphs)
  • If you own a stock with volatile returns over a 2-year period, will the average return be higher or lower than the geometric return? Explain why. (75–150 words, or 1–2 paragraphs)
  • Why is it more convenient to display your investment returns in percentage terms rather than dollar terms? (75–150 words, or 1–2 paragraphs)
  • Would a common stock or a corporate bond demand a higher risk premium? Explain why. (75–150 words, or 1–2 paragraphs)
  • What are the differences between a bond risk premium and an equity risk premium? (75–150 words, or 1–2 paragraphs)
  • Explain whether it is possible to earn excess returns without taking on additional risk. (75–150 words, or 1–2 paragraphs)
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Assignment

Investment Returns and Risk Premiums

Risk comes from not knowing what you are doing.

—Warren Buffett

How do you feel about the following statement: “Avoiding risks is the biggest risk of all”? That statement may seem contradictory at first, but it makes more sense if you apply the concept to various situations in life and business. For example, many people pursue a college degree because they feel it will increase their job prospects and earning potential. This can turn out to be true but is not a guarantee. Others may find this path too risky and prefer to enter the job market right away. Although the first group of people take the risk of their college degree paying off in the long run, the second group are also taking the risk of limiting their potential for the future. Similarly, the nature of entrepreneurship is built upon the risk of investing time and money into something that could potentially fail. Even established businesses could become outdated or be outperformed if they stop taking certain risks. Just as the concept of risk can apply in a general sense, it also applies to investments that individuals and businesses make. Calculated investment risks are not always guaranteed to pay off, but a zero-risk approach may not be as safe as it sounds either.

In this Assignment, you will address questions related to returns and risk premiums.

By Day 7

Submit your responses to the following prompts.

  • Explain the differences between the arithmetic return and the geometric return. Include in your explanation what factor determines the difference between arithmetic returns and geometric (compounded) returns. (75–150 words, or 1–2 paragraphs)
  • If you own a stock with volatile returns over a 2-year period, will the average return be higher or lower than the geometric return? Explain why. (75–150 words, or 1–2 paragraphs)
  • Why is it more convenient to display your investment returns in percentage terms rather than dollar terms? (75–150 words, or 1–2 paragraphs)
  • Would a common stock or a corporate bond demand a higher risk premium? Explain why. (75–150 words, or 1–2 paragraphs)
  • What are the differences between a bond risk premium and an equity risk premium? (75–150 words, or 1–2 paragraphs)
  • Explain whether it is possible to earn excess returns without taking on additional risk. (75–150 words, or 1–2 paragraphs)

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