Risk and return: application

As stated in Risk and return: an introduction, risk is a complex topic. There are many types of risk, and many ways to evaluate and measure risk. When it comes to investing, risk can be summarized simply as follows:


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 * Risk and return are inseparable. Higher returns generally can be achieved only by taking more risk. There is no free lunch.
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Variation of returns
As Figure 1 indicates, the return on bonds is less certain than the return on cash (Treasury bills), and the return on stocks is less certain than the return on bonds. Thus, bonds are considered riskier than cash, and stocks are considered riskier than bonds. However, as the risk increases, the average return also increases.



Figure 1. Risk vs. Return: 1928 - 2011
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Now, refer to Figure 2, which is Figure 1 but from a different perspective.

As stated in Risk and return: an introduction, uncertainty includes both gain and loss. Consideration must be given not only for the expected return (average), but also for the range of variation.

Figure 2 shows this graphically. When the return is higher than planned, a windfall is experienced. A lower return than planned is a shortfall.

Returns which go below 0% indicate a loss on the investment (if sold during this time), which is shown as "Loss."



Figure 2. Risk vs. Return for Three Asset Classes: 1928 - 2011
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Portfolio diversification
Now, combine those same assets into portfolios. Refer to Figure 3.

Going from left to right, the portfolio progresses from (20% stocks / 80% bonds) to (80% stocks / 20% bonds). Similar to Figure 2, the least variation and lowest return is a portfolio which contains mostly bonds. The highest variation and highest return is a portfolio containing mostly stocks.

As before, you will lose money on your investment if the return goes below 0% (if it is sold during this time).



Figure 3. Risk vs. Return for Various Portfolios: 1928 - 2011
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Figure 3 contains an additional metric - predicted maximum loss. In other words, you have a good chance (95%) that the return will be above this amount most of the time. In 2008, the returns went below that 95% level, which represented a significant impact for many investors.