Question

Compare the historical risk-return trade-off for stocks and bonds.

Answer 1

Higher risk is associated with greater probability of higher return while, lower the risk implies a greater probability of smaller return. This trade off which an investor faces between risk and return while considering investment decisions is called the risk return trade off.

the risk-return trade off also exists at the portfolio level. eg:- a portfolio composed of all equities both higher risk and higher potential returns. in that portfolio, risk and reward can be increased by concentrating investments in specific sectors or by taking on single positions that represent a large percentage of holdings. For investors, assessing the cumulative risk-return tradeoff of all positions can provide insight on whether a portfolio assumes enough risk to achieve long-term return objectives or if the risk levels are too high with the existing mix of holdings. Investors can invest in a wide variety of securities or assets with widely differing risks, the greater the risk, the greater the potential return, or risk premium, must be.

Two methods for risk reduction

Bond laddering- reducing interest rate risk is to buy bonds that mature at different times. This is known as laddering. Laddering can help reduce the risk that all of your bonds will mature at a time when interest rates are low. It also frees up cash at different times, so that investor can choose to reinvest or use as income.

Diversification - choosing a mix of bonds with different features, increase the chance that some of your bonds will perform well at times when others do not. eg:- a mix of government and corporate bonds, bonds that mature at different times, or more complex bonds like strip bonds or real return bonds.