Question

You have been hired to evaluate the risk versus return of two prospective investments. One is a venture capital fund which is expected to return 33% over the next year with a standard deviation of 40%, while the other is an emerging markets equity portfolio which returns 23% with a standard deviation of 20%. The risk-free rate for the year is 2%. Define and describe the criterion you would use to evaluate these two investments from a risk versus return perspective and calculate the result

Answer 1

Standard deviation is a absolute measure of risk. When we want to compare two or more securities having different average return and Standard deviation, the security's risk cannot be compared based on standard deviation.

One of the relative measure of risk to evaluate these two investments from a risk versus return perspective is Coefficient of variation. It is the ratio of the standard deviation to the expected return (mean).

Coefficient of variation for portfolio 1 =

40 / 33

= 1.21 (approx)

Coefficient of variation for portfolio 2 =

20 / 23

= 0.87 (approx)

In the question return of portfolio 1 is higher than of portfolio 2, but this cannot be said that the portfolio 1 is better as the returns are better, its risk is very high. The coefficient of variation of portfolio 1 is very high than of portfolio 2. Hence portfolio 1 is risky. For every percent of return more risk is there for portfolio 1 than for 2.

Hope it clarifies!