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11.7 The Bigger Picture

PLEASE NOTE: This book is currently in draft form; material is not final.

Learning Objectives

  1. Explain how risk and return play a role in financial management.
  2. Describe some ethical considerations regarding risk and return.

At the core of all of finance is the question of appropriate tradeoff between risk and return. We have looked in detail at one measure of risk, standard deviation, and further separated the portion due to the market and the portion that can be “diversified away”. As financial managers, we will need to evaluate projects based upon their returns and their potential contribution to non-diversifiable risk, since our investors will expect appropriate returns for the risk assumed. This will play a key part in our investigation of the cost of captial, which in turn will affect our evaluation of which projects our companies should undertake.

Furthermore, the concepts introduced in this chapter are the foundation of much of modern portfolio theory. Any who plan to study investments further will use these principles in constructing efficient portfolios.

Ethical Considerations

Analysis of risk involves many assumptions and calculations, and those who do not have the appropriate background can be very dependent upon the advice of we who have studied finance. An unscrupulous actor could misrepresent the actual risk of an investment to the detriment of clients, customers, investors, or management. For example, there are many cases of traders at large banks trying to hide the actual amount of risk they have in their portfolios, and they often aren’t discovered until their positions have lost much money. Or a dishonest investment advisor could put clients into assets that are overly risky given the clients’ age, income, or risk tolerance. Misrepresenting the risk of an investment is just as bad for the investor as misrepresenting the potential return.

Another area where ethics can play a part regards diversification. If we are trying to emulate a market portfolio, we might introduce stock positions in companies that engage in business practices that we disagree with. Thankfully, we don’t need to have a position in every company to reap most of the benefits of diversification, but ethical diversification is not just as simple as purchasing any broad market ETF.

Key Takeaways

  • Risk and return play a key part in determining a company’s cost of capital.
  • Misrepresenting risk is potentially as damaging as misrepresenting return!

Exercise

  1. You learn of an investment opportunity that expects great returns, but also has great risk associated with it. To raise the capital needed, you decide to ask your grandfather, who lives on a fixed income, to contribute. What questions might need to be considered to determine if this is an ethical course of action?