The Risk and Return on Stock and Bonds
Explain the historical relationships between risk and return for common stocks versus corporate bonds. Explain the manner in which diversification helps risk reduction in the portfolio. Support the response with actual data.
Usually, the higher the risk on an asset, the greater the return or potential for loss. Take stocks for instance, stocks have high growth potential, but its price changes considerably during the year. Volatility is a term used to describe this occurrence and is a risk factor that must be considered when making investments. For example, the average 10-year (after inflation) 70/30 portfolio (bond) is approximately 47%. An individual who is closer to retirement may choose to invest less in stocks because he or she cannot afford to take the risk. On the other hand, younger investors have more time and can deal more effectively with market fluctuations.
Another consideration is when a person invests in a government bond that pays a certain percentage of yield over a specific number of years (e.g., 2% yield for ten years), and the investor gets a return on his or her principal. In this scenario, there is less risk, with less reward. As a rule of thumb, an investor’s portfolio should include risky and less risky investments. The investor should also invest in a variety of asset classes that show little correlation with each other (e.g., no movement, up and down in lockstep).