Investors generally dislike uncertainty or risk and agree that a safe dollar is worth more than a risky one. Therefore, investors will have to be persuaded to take higher risk by the offer of higher returns. This chapter is the first of three chapters dealing with the risk and return trade-off, and its implications to corporate finance. The chapter defines risk faced by individual investors holding portfolios of securities. The next two chapters will connect this to the opportunity cost of capital for corporations.

The chapter starts with a detailed description of the historic performance of different securities in the U. S. capital markets. This lesson is used to provide basic benchmarks for risk and return. The chapter also describes how we can measure the risk of securities and the role of diversification in reducing risk. The statistical measures of variance and standard deviation are used to measure the risk of individual securities and portfolios. Individual stocks are more risky than portfolios. As the number of the stocks in a portfolio increases, the risk of the portfolio is reduced. The reduction in risk however levels off once the number of stocks in the portfolio reaches a certain number. Thus, there is a certain level of risk that you can never diversify away. This undiversifiable risk stems from economy-wide perils that affect all businesses; it is called market risk. The risk a security adds to a well-diversified portfolio depends on its market risk. This risk is called beta and finds extensive applications in later chapters.

Statistics: This chapter uses some basic statistical concepts and will be easy to follow if you already know some elementary statistics. The text gives all the necessary definitions, but you may want to refresh your memory from a statistics textbook. It will help if you are familiar with the terms such as variance, standard deviation, and covariance, and normal distribution.