Question

Compare and contrast the concepts of risk and return. Also discuss the importance of portfolio diversification and its relationship to risk and return.

Answer 1

Risk is directly related to return. Higher the risk higher will be returned and lower the risk lower will be the return. For instance investment in bonds is considered to be a low risk investment due to the certainty of interest payments. So it is historically seen that the returns from the bonds are lower due to the low risk involved. On the other hand the returns from stocks are very high but there is a high risk due to constant fluctuations in the stock market.

Due to this very reason portfolio diversification is very important. This implies that the investor must make use of a basket of different assets rather than putting all his money into one type of asset. By diversifying his portfolio the investor he is able to lower the risk of different Investments and at the same time the total return of the portfolio increases.