Question

Characterize the historical return, risk, and risk-return relationship of the stock, bond, and cash markets. Explain the risk-return trade-off.

Assume that you are 25 years old and you inherited $5,000 from your grandmother. You would like to invest the money either for your retirement in 40 years or for a vacation to Europe in two years. Would your tolerance for risk vary, depending on when you planned to use the money? Relate the risk-return trade-off to your plans for the $5,000.

Answer 1

The time frame of investment is critically important when making any decision

If the $5,000 is to be used for a European vacation, the time frame is small of 2 years. Therefore, the risk that you can take is very less. Therefore, you would typically invest in bonds and fixed income funds that have less volatility and stable returns.

On the other hand, if you want to save for retirement, you have a very long investment horizon of 40 years and in this case equity would be the best asset class since you can tolerate more risk. Equity investment takes a lot of volatility and gives the highest return over the long term.