Risk and Diversification: The Risk-Reward Tradeoff
AAA
  1. Risk and Diversification: Introduction
  2. Risk and Diversification: What Is Risk?
  3. Risk and Diversification: Different Types of Risk
  4. Risk and Diversification: The Risk-Reward Tradeoff
  5. Risk and Diversification: Diversifying Your Portfolio
  6. Risk and Diversification: Conclusion

Risk and Diversification: The Risk-Reward Tradeoff


The risk-return tradeoff could easily be called the iron stomach test. Deciding what amount of risk you can take on is one of the most important investment decision you will make.

The risk-return tradeoff is the balance an investor must decide on between the desire for the lowest possible risk for the highest possible returns. Remember to keep in mind that low levels of uncertainty (low risk) are associated with low potential returns and high levels of uncertainty (high risk) are associated with high potential returns.

The risk-free rate of return is usually signified by the quoted yield of "U.S. Government Securities" because the government very rarely defaults on loans. Let's suppose that the risk-free rate is currently 6%. Therefore, for virtually no risk, an investor can earn 6% per year on his or her money. But who wants 6% when index funds are averaging 12-14.5% per year? Remember that index funds don't return 14.5% every year, instead they return -5% one year and 25% the next and so on. In other words, in order to receive this higher return, investors much also take on considerably more risk.

The following chart shows an example of the risk/return tradeoff for investing. A higher standard deviation means a higher risk:


In the next section, we'll show you what you can do to reduce the risk in your portfolio with an introduction to the diversification.
Risk and Diversification: Diversifying Your Portfolio

  1. Risk and Diversification: Introduction
  2. Risk and Diversification: What Is Risk?
  3. Risk and Diversification: Different Types of Risk
  4. Risk and Diversification: The Risk-Reward Tradeoff
  5. Risk and Diversification: Diversifying Your Portfolio
  6. Risk and Diversification: Conclusion
RELATED TERMS
  1. Complete Retention

    A risk management technique in which a company facing risks decides ...
  2. Alternative Risk Transfer (ART) Market

    The portion of the insurance market that allows companies to ...
  3. Investment Income Ratio

    The ratio of an insurance company’s net investment income to ...
  4. Adjustable Feature

    Contract language that allows adjustments to be made to the premium ...
  5. Development To Policyholder Surplus

    The ratio of an insurer’s loss reserve development to its policyholders’ ...
  6. Overall Liquidity Ratio

    A measurement of a company’s capacity to pay for its liabilities ...
  1. What are the risks involved in keeping my money in a money market account?

    Setting aside funds in a money market account can be a safe investment strategy, but investors should be aware of the risks ...
  2. How effective is creating trade entries after spotting a Sanku (Three Gaps) Pattern?

    Learn about the sanku, or three gaps, pattern including formation, interpretation and additional confirmation necessary to ...
  3. How do I build a profitable strategy when spotting a Rounding Bottom pattern?

    Understand the basics of the rounding bottom pattern, also known as the saucer, including formation and optimal entry and ...
  4. How do I build a profitable strategy when spotting a Runaway Gap pattern?

    Understand the basics of the runaway gap and how to utilize this pattern to establish profitable trade strategies, including ...

You May Also Like

Related Tutorials
  1. Bonds & Fixed Income

    Investing For Safety and Income Tutorial

  2. Economics

    American Depositary Receipt Basics

  3. Investing Basics

    Stock Basics Tutorial

  4. Options & Futures

    Beginner's Guide To Trading Futures

  5. Trading Strategies

    Introduction To Order Types

Trading Center