Question

1. Discuss the concept of the risk-return trade-off and how it may apply in different circumstances.

2. Outline the risk-reduction benefits of diversification of an investment portfolio. In your answer, briefly discuss how portfolio diversification works in principle to minimise overall investment risk.

Answer 1

Answer(1): Risk-return trade-off- This states that higher return comes when you take high risk, It is said, "More risk more gain". Until you high risk, you cannot gain above average. Return on any asset rises with the increase in risk. When uncertainty is lower, return will also be lower and when uncertainty will be higher, return will also be higher.

Application of risk-return trade-off in different circumstances-

In equities- When you invest in risk free Government securities, you get fixed but lower returns, same applicable with fixed income securities, you get fixed lower returns with lower risk but if you invest into equity, it has more risk than any other investment alternative but in provides higher potential returns too.

In business- If you open a start up company, you do not know when you will get cash inflows and risk is there, your business will work or not so you take risk in doing business but if your business grows and give you profit, your risk will pay you very soon.

Answer(2): Yes, It is true. Portfolio diversification decreases the risk and increases the return, It is said, "Do not put all your eggs in one basket". Here are some benefits of diversification:

1. Overall portfolio risk is minimized by diversification, you cannot stop the risk but can control the risk by diversifying your portfolio, investors should not invest into one asset class or one sector as if that particular sector comes down, value of your portfolio comes down, they should invest in different stocks of different sectors so that if one sector comes down, other sector will do good then the portfolio will be balanced.
2. Your capital will be secured by diversification, You will not lose it and it will generate return for you, you will get above average returns.