$1.$ Basic concepts $-$ Risk and return

Professor Isadore $($Izzy$)$ Invest$-$a$-$Lot retired two years ago from Exceptional College, a small liberal arts college in Pennsylvania after teaching corporate finance and investment theory for $35$ years. Yesterday, Izzy appear on EC LIVE, a television show produced for the students, faculty and staff on the EU campus and the local communities. Barbara Bighair is the host of EC LIVE, and one of Professor Izzy$$s former students.

The following is a transcript of the interview. Unfortunately the software that transcribes the interview into written form failed to understand several words and phrases used in the interview. To complete the transcript and demonstrate your knowledge of the risks and returns of investing, please select the best answer from each dropdown menu.

BARBARA: Good morning, Professor Invest$-$a$-$Lot. I$$d like to welcome you to EC LIVE, and thank you for coming in today to offer us insights into the basics of investing. I remember your course well, and while my grades didn$$t always reflect great success, I was always very interested in the material and the possibility of using the concepts and techniques when the opportunities arose.

IZZY: Good morning, Barbara, and please call me$,$ Izzy. Thank you for the invitation to discuss one of the important fundamentals to sound investing: an appreciation of the relationship between the objective or outcome of your investment, that is its return, and the likelihood of receiving it$,$ or the investment$$s $($Risk OR Return$).$

IZZY: An investment$$s risk, or the probability that it generates a return that is $($Equal to $-$ Greater or less than$)$ its expected return, can be considered from two perspectives: that of $($an independent OR a stan $-$alon$)$ asset, or a single$-$asset portfolio, and that of a multiple$-$asset portfolio.

The risk of a single asset is best measured by the $($Variance OR Standadr deviation$)$ of the asset$$s possible outcomes, while the risk of an asset in a multiple$-$asset portfolio is best measured by its $($Variance OR beta coefficient$).$

BARBARA: Now, I seem to recall that there are two major types of risk affecting a security: systematic and unsystematic risk. What is the difference between them, and is there a way to reduce your exposure to them?

IZZY: Those are fantastic questions!

Systematic risk, also called $($Non$-$diversifiable OR diversifiable$)$ or market risk, results from phenomena that affect the majority of firms and securities$.$ Since the events or circumstances that give rise to market risk affect most firms, it $($is not OR is$)$ possible to diversify away this type of risk.

Unsystematic, or company$-$specific, risk, on the other hand, is $($diversifiable or Non$-$diversifiable$)$ because it results from events and phenomena that are unique to a particular individual firm. Examples of these events or phenomena include, but are not limited to$,$ earthquakes and tornados, labor unrest and strikes, and lawsuits or marketing campaigns. As these occurrences are $($non$-$random OR Random$),$ an investor$$s unsystematic risk can be diversified away by $($Increasing OR decreasing$)$ the number of securities held in the investor$$s portfolio.

The reduced riskiness of the market portfolio is reinforced by noting that the standard deviation of the average single$-$stock portfolio is $35\%,$ whereas the standard deviation of the market portfolio, which is assumed to contain approximately $(1000$ OR $2,000+)$ stocks, is $20\%.$ Therefore, the addition of more and more randomly selected stocks to the portfolio $($reduces OR increases$)$ its riskiness.

BARBARA: That makes sense. So what does this mean for the returns earned on an investment?

IZZY: In short, it means that a rational investor can only expect to be compensated for his or her exposure to $($Unsystematic or company specific OR systematic or market$)$ risk. He or she will not be compensated for the $($diversifiable or non$-$ diversifiable$)$ risk that could be eliminated by increasing the size of his or her portfolio.

BARBARA: So$,$ the market will not compensate me for not doing what a rational investor could$$and should$$do$.$ Is that right?

IZZY: That is absolutely correct. The fact that you, as an investor, do not choose to act rationally $($will not $-$ will$)$ be compensated.

BARBARA: Izzy, this is fascinating stuff. Unfortunately our time is up$,$ but I$$d like very much for you to come back next week to continue our discussion. Would that fit into your schedule?

IZZY: Of course, and I$$ll look forward to it$!$ However, before I leave, I$$d like to ask you and the audience to take a pop quiz. It addresses the material discussed today and several related concepts. It is intended to reinforce some of the important risk$-$and$-$return$-$related concepts. Have fun, and I$$ll see you next week!