Introduction to financial modelling Assignment Example | Topics and Well Written Essays - 3500 words

Introduction to financial modelling - Assignment Example From figure 3 below, it is clear that, as the volatility for Standard & Poor’s (S&P) SMALL CAP 600 Index increases, the average rate of return declines rapidly up to a point where, if the volatility level continues to increase, the average returns start to increase rapidly (Lachance, 2003). In effect, when this portfolio is less volatile, its average return tends to decline, but when the rate of volatility is very high, the average returns tend to increase. In situations of high volatility, the risk of a stock tends to be high while on the other hand, when a stock is less volatile, its return is almost assured and hence less risky. The characteristic exhibited by this portfolio is that an investor should expect to make more returns when the stock is highly volatile. As such this stock is suitable for those investors who are comfortable with highly volatile stocks, who invest with the expectation of getting high returns. Considering that I am a risk averse investor, and would prefer stocks with more stable incomes even if it means lower returns - I would not go for this stock (Merton, 1969). From figure 4 below, the pattern of the graph has an implication that higher returns are expected in situations of less volatility. This is precisely the type of portfolio that suits my risk profile because I can invest in conditions of low volatility and still expect some returns albeit low. This also shows that this index performed better, as it is less volatile and hence almost guaranteeing investors some returns. The chance of getting returns from the S&P portfolio is very uncertain and hence considered as having performed poorly on such grounds (Milevsky, 1998). If I invested in equal amount in the above two portfolios, I could have formed a diversified investment, which could have balanced my risk with return. The S & P portfolio is more risky, but attracts higher returns while the New