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6. Risk and Return

Risk and reward go hand in hand and have a direct relationship. Return is the reward that a person gets for taking risk.

6.1 Measures of Risk

We will first look at the various measures of risk, that is how risk can be measured and a particular investment can be gauged.

The various measures of risk are discussed below:

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  • Variance- It measures how the investment is dispersed. The larger the variance for an expected rate of return, the greater the dispersion of expected returns and the greater the uncertainty, or risk, of the investment. It should be noted that, in perfect certainty, there is no variance of return because there is no deviation from expectations and, therefore, no risk or uncertainty.
  • Standard Deviation- it is the square root of the Variance and even this measure is widely used to measure the risk associated with an investment.

In certain investment cases, a simple variance or standard deviation can give misleading results if the conditions for two or more investment alternatives are not similar. So we use an adjusted measure called as coefficient of variation (CV). It is calculated as:

Standard rate of return/Expected rate of return

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