Advanced Diploma of Financial Planning (ADFP) Practice Test

Which financial concept explains the variability of an investment's return relative to the market?

1. Standard deviation

2. Return on equity

3. Beta

4. Asset allocation

The correct answer is: Beta

The correct answer, Beta, is a financial concept that measures the sensitivity of an investment's return to the movements of the broader market. It assesses how much an investment's price is expected to change in relation to market movements. A beta of 1 indicates that the investment's price is expected to move in line with the market. A beta greater than 1 implies higher volatility compared to the market, meaning the investment is expected to experience larger fluctuations in returns. Conversely, a beta less than 1 suggests lower volatility, indicating that the investment's price is less sensitive to market changes. Understanding beta is crucial for investors as it helps them gauge the risk associated with a particular investment relative to overall market risks. This metric is particularly valuable in portfolio management, as it can aid in determining how the addition of a particular investment might affect the overall risk and return profile of a portfolio. While standard deviation measures the total risk or variability of investment returns, it does not specifically indicate how that risk correlates with the market. Return on equity is a profitability ratio and does not relate to market variability. Asset allocation refers to the strategy of dividing investments among different asset categories but does not directly explain the variability of an investment's return in relation to the market.