The relationship between risk and expected return is typically described as line
ID: 2621500 • Letter: T
Question
The relationship between risk and expected return is typically described as linear (e.g. the Security Market Line or SML). What is the relationship in terms of the slope of the SML? Why is this important?
A conservative investment advisor foresees a downturn in the economy and recommends low risk investments. An aggressive investor has a very positive outlook and recommends taking a higher risk. What advice do you take? Discuss the effect of the advice received on your long term asset allocation.
Explanation / Answer
1) The market risk premium is determined from the slope of the SML. The security market line is a useful tool in determining whether an asset being considered for a portfolio offers a reasonable expected return for its risk. Individual securities are plotted on the SML graph. If a security's risk versus expected return is plotted above the SML, it is undervalued because the investor can expect a greater return for the inherent risk.
2)Companies should begin the selection process by discussing and writing out their goals and objectives. These goals and objectives should coincide with the investment policy. If they do not, then the investment policy will need to be revised. The company will also need to determine which type of manager they are looking for