Risk, Return and Diversification

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Imagine you have the option to invest in three different opportunities: A, B and C. Let’s also say that you have analyzed the risks and you believe you can classify them as low-risk, medium-risk and high-risk, respectively. Which of these three opportunities would you need to provide the greatest return in order to invest in it?

Now let’s say the returns of opportunities A and B are highly correlated with the market as a whole but those of opportunity C have a very low correlation with the overall market. Would this information potentially change the required return you imposed on the opportunities in order to invest in them if so, why?

Now imagine that another investor views the risks to be exactly the opposite of your view (that is, she views opportunity C to be the least risky, followed by B and then A). Assume your view of the risks is the same as described earlier. Does this change the required return you need in order to invest in the different opportunities?

 

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