Safety First Rule

Posted in Finance, Accounting and Economics Terms, Total Reads: 586
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Definition: Safety First Rule

The Safety first criteria is the principle of selecting the investment portfolio by minimizing the probability of the return falling below a certain minimum value. Thus by fixing the minimum return, the investor reduces the risk of not achieving the investment return.


For eg there are 2 portfolios such as B and C which gives certain return. Now the investor has set his sight on a minimum return of 1%. Then utilizing Safety First rule he will try to select the portfolio which would give the maximum probability of the returns being at least greater than 1 %.


Thus from the safety first rule , if there are i portfolios and P(Ri< R) signifies the probability of the return from ith asset lesser than the minimum fixed R. The formula stands to be

Min P(Ri < R) for all i


It has been seen that if the portfolios have a normal retun function then the safety first criterion can be reduced to the maximization of


Max SFi = E(Ri` )- R / sqrt(Var(Ri ))


Where E(Ri` ) is the expectation of return from the ith portfolio, Var(Ri ) is the standard deviation and r is the minimum stipulated return.


For eg, portfolio B has a return of 9% and standard deviation of 12 %; similarly C has a mean return of 10 % and deviation of 5%and the investor is willing to fix his minimum return R as 0%


Then SF ratio for B = (9-0)/12= 0.75 ; SF ratio for C will be = (10-0)/5 = 2. Thus using safety first criteria the investor would go for the C investment portfolio.

 

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