Risk and Return

The objective of an investor is to obtain the largest possible rate of return without placing invested funds at more risk than is bearable. Your reluctance to assume risk limits your ability to maximize returns. Investors should not assume the risk of greater loss than they can afford. The basic idea -- maximize return and minimize risk.

Probability and the Holding Period

Return = Money You Get
The rate of return is the most important outcome from any investment. Both the gain in an assets value over time (the capital gain) and the monies received while holding an asset (the cash dividend) are of interest to any investor. If you add the cash you receive in hand (like interest payments and dividends) together with any capital gain and divide it by the purchase price, you then know the true return on your money.

Capital Gain (or loss) + Cash Dividend / Purchase Price =
THE RETURN ON YOUR INVESTMENT

Probability = The Chance That You Get The Money
A probability is a number that describes the likelihood of "something." Probabilities can vary from 0 to 100 percent. An investor who examines the probability of receiving a return will see that there are many investments with little risk and reasonable rates of return -- like U.S. Treasury Bills. Usually, investments that yield a higher rate of return involve more risk.

In fact, (unlike Treasury Bills) high yield investments will require that you risk your principal. That is to say: you could loose all of the money that you invest. Most people are averse to risk giving it the name, risk-aversion. For instance, when you buy a publicly traded stock, you could loose your entire investment.

On the other hand, if you didn't invest in the stock market during certain periods of history, you would have forgone huge profits. That is called profit-aversion.

To be totally risk-averse or totally risk-tolerant does not appear to be the best investment strategy. So, what we are looking for is a sane approach to risk management.

Risk
Assets having a greater probability of loss are felt as "more risky" than those with a lesser chance of loss. The trick is getting the greatest rate of return with the least amount of risk. A common approach to evaluating the risk of an asset involves estimating the pessimistic (worst), the most likely (expected), and the optimistic (best) return associated with a given asset. If you take a group of investments and plot the estimated risk against the return, it usually looks like this --

Diversification

In order to reduce overall risk (the steepness of the above graph) it is best to acquire, or add to the existing portfolio, assets that are not related. The technical term for this is not putting all your eggs in one basket. That way if you trip, you won't break all the eggs. Now let's translate that over to your money:

The creation of a portfolio by combining two assets that behave exactly the same way cannot reduce the portfolio's overall risk below the risk of the least risky asset. (Here comes the important part)The creation of a portfolio by combining two or more assets that behave exactly opposite can reduce the portfolio's total risk to a level below that of either asset alone -- which in certain situations may be zero.

Your well diversified portfolio will look more like this:

How to Best Diversify Your Portfolio

Have your funds invested in more than one asset (or more than one type of asset.) For instance, if your company gives you stock as a bonus or part of your benefits, you should consider investing some of it in other unrelated assets. What if your industry takes a beating, you lose your job, and the value of your "savings" is cut in two? Another example is leaving cash in a bank account (or equity in your house.) Though the risk is low, so is the rate of return. By spreading the funds to other assets, the increase in risk will only be slight, whereas the increase in rate of return will be great.

Here are some examples of stock portfolios.

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