Risk and return: application

As shown in Risk and return: an introduction, risk is a complex topic. But when it comes to investing, risk can be summarized as follows:


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 * Risk and return are inseparable. Higher returns can only be achieved by taking more risk. There is no free lunch.
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Exceptions are few and far between. The example below uses historical data to demonstrate that, in general, owning stocks is riskier (has more variation in returns) than bonds. You can mitigate (reduce) this risk by diversifying your portfolio.

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.



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.

The Treasury bonds and bills have been combined into a single category called "bonds." This is done intentionally, as asset classes which contain  bonds and  bills are commonly grouped into a class called "Fixed Income." This asset class contains securities which have a fixed periodic return on your investment and can contain cash and cash equivalents such as money markets or  CDs.

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.



Figure 3. Risk vs. Return for Various Portfolios: 1928 - 2011
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This demonstrates that one can reduce their portfolio risk by adding bonds, but may result in a lower return. Alternatively, one can increase their return by adding stocks, at an increased risk of loss.

Caveat: Figure 3 shows a hypothetical portfolio of assets held from 1928 - 2011 and should not be compared with an actual portfolio. The arrow lengths are used to show relative variation only. Also, do not assume that the returns vary evenly (linearly) across the portfolio percentages.