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

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
Related Articles
  1. Investing

    Measuring a Fund's Risk and Return

    Learn the importance of the risk-return relationship in selecting a mutual fund.
  2. Investing

    Smart Beta Strategies: Comparing a U.S. vs. Global Approach (VT, VGTSX)

    Examine the importance of investing in stocks outside of the United States. Portfolio theory indicates that a modest portion should be invested in global stocks.
  3. Retirement

    3 Retirement ETFs Suitable for Your Portfolio

    Building a retirement portfolio which is in accordance with your needs as well as risk tolerance is certainly difficult. Suitable ETFs can help with that.
  4. Investing

    Why Risk-Free Investments Don't Exist

    We explain the risks inherent with all types of investments and why risk-free investments do not exist.
  5. Investing

    Understanding Market Risk Premium

    Market risk premium is equal to the expected return on an investment minus the risk-free rate. The risk-free rate is the minimum rate investors could expect to receive on an investment if it ...
  6. Investing

    The Risks Associated with Common Investments

    Investing inherently involves some risk. Here are some of the different types of investment risks.
Frequently Asked Questions
  1. I have a profit-sharing plan with my former employer. I am now trying to buy a home. Can I use my profit-sharing money to put a down payment on a house?

    Whether you can use your profit-sharing funds depends on constraints that may prevent you from withdrawing the money from ...
  2. What is the difference between systemic risk and systematic risk?

    Systemic risk generally refers to an event that can trigger a collapse in a certain industry or economy as systematic risk ...
  3. What is accrued interest, and why do I have to pay it when I buy a bond?

    An investor who sells a bond must be compensated in coupon payments for the period they owned the bond, defined as the interest ...
  4. What is the history behind the opening and closing bells on the NYSE?

    Similar to school bells, the New York Stock Exchange's (NYSE) opening and closing bells mark the beginning and the end of ...
Trading Center