Market prices, Valuation Principle, Net present Value, interest rates, Essay - 4

Market prices, Valuation Principle, Net present Value, interest rates, and bonds - Essay Example For several reasons investor would be interested in periodically checking value of actual return on investment, primary reason has to do with stability of portfolio itself. If the overall rate of return is low or is likely to decrease, it signals that diversification in investment types would be needed. Despite diversification, loss in return on investment indicates that one or more investment types are composed of higher percentage of total investment than desired. In both cases, lower than expected value of realized return can convince investor to make changes in order to avoid incurring further losses. Systematic risks are fluctuations in stock’s return due to factors beyond market control and it can not be eliminated through diversification. Systematic or non-diversifiable risk is a common risk affecting all stock; causes include wars, inflation, political events and international incidents. Risk free rate of return is used to compensate this risk type. On contrary, unsystematic risks are fluctuations of stock’s return associated with random causes that can be eliminated through portfolio diversification. Unsystematic or diversifiable risk is a firm-specific risk, contributing factors include lawsuits, strikes or regulatory actions and market risk premium is used to compensate such risk. Total risk of portfolio is not simply equal to the weighted average of the risk of individual securities in the portfolio because of continuous diversification. Such diversification reduces portfolio’s total risk though all risks cannot be diversified. Risk factors (economic conditions, interest rates) of all stocks, bonds, securities are almost same and cannot be eliminated, whereas investors can eliminate systematic risk to some extent by portfolio diversification. Addition of more securities drops down unsystematic risk, until total risk approaches to systematic risk. The fact that diversification is