The risk-return tradeoff is something every investor must consider when designing their portfolio. Simply put, the risk-return tradeoff states that uncertain investments have the potential for greater returns than certain investments. This makes sense logically, as the only reason someone will invest in a high-risk asset is if they expect to receive a return proportionate to the risk they have taken on.
A classic example of this tradeoff is investing in stocks and bonds. Stocks are inherently a risky investment. They are reliant on constant innovation for growth, and even the largest companies can fail seemingly out of nowhere. 88% of Fortune 500 companies that existed in 1955 are no longer on the market, either through bankruptcy, mergers, or decline in business. Bonds, on the other hand, are a relatively certain investment. The risk-return tradeoff even emerges within stocks or bonds. Investing in a small startup company implies a different risk level than investing in Amazon and investing in a government bond is different than buying a junk bond. The chart below demonstrates this tradeoff between varying levels of stocks and bonds using standard deviation (how far away from the average return each annual return could reasonably be) to show that the higher the risk taken on by a portfolio, the higher the average return.
Given the risk-return tradeoff, it is important to think about how to maximize returns while minimizing risk in your portfolio. One way to accomplish this is to invest for the long-term. While your annual portfolio return could be anywhere on the standard deviation lines shown above (or even above or below the lines on outlier years), by holding a portfolio for many years your total returns will likely settle to the average annual return. Another protection from risk within stocks is to invest in highly diversified mutual funds or ETFs. While a single stock can be unpredictable, holding many stocks within a fund generally maximizes returns without investors having to worry about one company failing. More than anything, it is important to decide what risk tolerance and investment allocation is right for you and stick with it. For more information on how we can help you invest to achieve your financial goals, visit our website www.kdminvest.com.