The Importance of Risk

An investor is interested not only in the return which he expects to receive from his investment but also in the risk attached to the investment. This risk may be defined as the probability that he may sustain a financial loss by investing in a particular company. To minimize the risk associated with investing in one company only, the sensible investor will seek to spread his investment over several companies. In effect, the investor will consider the purchase of one particular security in the context of a portfolio of securities.

It is a basic tenet of portfolio theory that rational investors will prefer to hold portfolios of securities which maximize the expected return for a given degree of risk, or which minimize the degree of risk for a given expected rate of return. The individual investor is required to decide for himself the risk he is willing to bear in exchange for the prospect of larger returns, for evidently the larger the returns, the greater the degree of risk usually associated with such returns. In effect, the decision which he makes reflects his personal risk preferences. The portfolio of securities which an individual will choose will reflect his relative risk preference, and will require predicting the risk associated with the individual securities comprised in the portfolio. It is evident that the analysis of the financial reports of companies should assist individual investors in selecting portfolios of securities.

The development of portfolio theory has been extended beyond the analysis of risk and the selection of securities by means of studies in capital asset pricing. Capital asset pricing models seek to explain the manner in which asset prices are determined in relation to the risk attached to the returns involved. Whilst a more extensive review of the significance of portfolio theory is beyond the scope of this text, research in this area shows the significance of risk to the investor, and the manner in which the returns which he expects are associated with risk categories

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Read on: Other Research Findings

We stated that the implications of research findings are important for considering the future development of financial reporting. In this section we examine recent research which has a bearing on this problem.

The efficient market hypothesis

In a perfectly competitive market, it is an axiom of economic theory that the equilibrium price of any commodity or service is established at that point where the available demand is matched with the available supply. The equilibrium price reflects the consensus of those trading in the market about the true worth of a good or service, which... see: Other Research Findings