4.15:
Portfolio Risk and Return
Portfolio risk and returns refer to the potential risks undertaken and the rewards achieved from investments.
The risk associated with a portfolio refers to the volatility of returns from expected outcomes. Higher risk is associated with higher returns and significant losses, while lower risk is associated with low returns and negligible losses.
Consider Kate. She considers three portfolios. Portfolio A is invested in government bonds and bank deposits, which are considered low-risk and have stable but relatively low returns.
Portfolio B is invested in a mix of stocks, which are considered higher risk due to their potential for significant price fluctuations but offer higher average returns than bonds.
Kate can choose the portfolio based on her risk tolerance, time horizon, and expected returns.
To manage portfolio risk, Kate uses diversification by spreading her investments across asset classes like stocks and bonds and sectors such as technology and healthcare.
This strategy aims to reduce risk by offsetting the negative performance of some investments with the positive performance of others.
4.15 Portfolio Risk and Return
Portfolio risk and return are fundamental concepts in investment management, encapsulating the potential rewards from investments and the risks undertaken to achieve these rewards. The relationship between risk and return is central to making informed investment decisions and constructing an optimal portfolio.
Portfolio risk refers to the uncertainty and variability in the returns generated by a portfolio. It is influenced by the volatility of the portfolio's individual assets and how they interact with each other. Higher portfolio risk implies greater potential for significant deviations from expected returns, both positive and negative.
Portfolio return is the gain or loss generated by the portfolio over a specific period. It reflects the combined performance of all the assets within the portfolio, including income from dividends, interest, and capital gains. The return of a portfolio is inherently linked to its risk profile; generally, portfolios with higher risk have the potential for higher returns, while those with lower risk tend to offer more stable but lower returns.
Volatility measures the degree of variation in returns from the expected outcome over a given period. This variation is influenced by factors such as market conditions, economic cycles, and specific events impacting individual assets or sectors. Higher volatility signifies greater uncertainty in returns, leading to increased risk. Typically, higher-risk portfolios are anticipated to provide higher returns to compensate for the heightened uncertainty and potential for substantial losses. On the other hand, lower-risk portfolios usually deliver more stable, though lower, returns with minimal risk of significant losses.