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. However, when it comes to investing, risk can be summarized simply as follows:


 * “Risk is the uncertainty that an investment will earn its expected rate of return.”

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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This demonstrates one of the most fundamental axioms of investing: ''Risk and return are inextricably related. Higher returns generally can be achieved only by taking more risk, but because the risk exists, the higher expected returns may not result in higher realized returns.''

Portfolio planning
When planning a portfolio, uncertainty means that one must consider both a gain and a loss.

Plan for $$E$$xpected return, but can have windfall / shortfall.



Figure 2. Risk vs. Return: 1928 - 2011
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