Question

IN DEPTH ANSWER PLEASE

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

1. When a financial investment is made then there is a possibility of getting lower returns than expected. The uncertainty is the risk involved in the investment. The balance between the risk involved and the return obtained is known as the risk return trade off. This can be applied in different situations when people invest in different investment options. For example: a person who wants to get high return at low risk will invest in treasury bonds while a person who is willing to take high risk for getting high return will invest in the equity market.

2. In order to be able to manage the risk and return properly, investors should diversify their portfolio. Diversification of portfolio means that the investor should have his or her money in a wide variety of investments. These investments should have different characteristics and should vary in their risk and return behaviours. The idea here is that if there is an investment which is very risky and giving low returns then the risk will be overcome by having another investment where the risk is less and the return is more. There will be an offsetting effect of the two investments on each other. For example: the investment in equity shares can be offset by making investment in gold or bonds. This is the advantage of diversifying one's portfolio of investments.