Relationship between risk and return 

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Relationship between risk and return

By now you should understand that even with the most conservative investments you face some element of risk. However, not investing your money is also risky. For example, putting your money under the mattress invites the risk of theft and the loss in purchasing power if prices of goods and services rise in the economy. When you recognize the different levels of risk for each type of investment asset, you can better manage the total risk in your investment portfolio.

A direct correlation exists between risk and return and is illustrated in Figure 4–2. The greater the risk, the greater is the potential return. However, investing in securities with the greatest return and, therefore, the greatest risk can lead to financial ruin if everything does not go according to plan.

Figure 4-2 Risk and Return
Risk and Return

Understanding the risks pertaining to the different investments is of little consequence unless you’re aware of your attitude toward risk. How much risk you can tolerate depends on many factors, such as the type of person you are, your investment objectives, the dollar amount of your total assets, the size of your portfolio, and the time horizon for your investments.

How nervous are you about your investments? Will you check the prices of your stocks daily? Can you sleep at night if your stocks decline in price below their acquisition prices? Will you call your broker every time a stock falls by a point or two? If so, you do not tolerate risk well, and your portfolio should be geared toward conservative investments that generate income through capital preservation. The percentage of your portfolio allocated to stocks may be low to zero depending on your comfort zone. If you are not bothered when your stocks decline in price because with a long holding period you can wait out the decline, your portfolio of investments can be designed with a higher percentage of stocks. Figure 4–3 illustrates the continuum of risk tolerance.

A wide range of returns is associated with each type of security. For example, the many types of common stocks, such as blue-chip stocks, growth stocks, income stocks, and speculative stocks, react differently. Income stocks generally are lower risk and offer returns mainly in the form of dividends, whereas growth stocks are riskier and usually offer higher returns in the form of capital gains. Similarly, a broad range of risks and returns can be found for the different types of bonds. You should be aware of this broad range of risks and returns for the different types of securities so that you can find an acceptable level of risk for yourself.

Figure 4-3 Continuum of Risk Tolerance
Continuum of Risk Tolerance

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