Return and Risk of a Portfolio

A portfolio is a collection of assets.

It is always better to spread one's investment over a group of assets in order to minimize risk. This is called diversification. How does the risk reduce by doing so? The risk reduces because the loss in one asset can be offset by the gain in another.

It is important to keep in mind that risk reduction will happen if the returns from the assets that comprise the portfolio are not positively correlated. For instance, it does not make sense to have a 2 - asset portfolio, where both assets are of the same category and nature. Then, rather than reducing the risk, we would be doubling it.

Also, the risk of a portfolio responds to the weights of individual assets. Therefore, the amount of money invested in each asset is important in reducing risk. Through portfolio optimization techniques (for example, Markowitz's mean  - variance model), one can decide exactly what proportion of the portfolio should be invested in each asset to arrive at minimum risk.

We should not get carried away by the idea of not keeping all our eggs in one basket. If we have too many baskets, it becomes progressively difficult to monitor each one of them. There is always an optimum number of assets that should form a portfolio. More than that will lead to superfluous diversification, meaning that the cost and effort to track the portfolio will be more than the benefit from it.

The following video demonstrates the computation of return and risk for a portfolio of assets:

Return and Risk of a Single Asset

The concept of Time Value of money says, and it is rational too, that a dollar (or whatever currency is relevant for you) received today is more valuable than receiving it tomorrow. We still find that a lot of people postpone current receipt in favor of a future one. We often commit our funds to one or the other investment. Why do we do that? Well, of course, we are expecting our money to grow with time and for that to happen, the sacrifice of current income that we make today, should provide us some reward in the future. We call this reward, return.

We all know that future is uncertain and though we would like to see everything proceeding as per plan, things do go awry often. The last couple of years are recent testimony to this. It means therefore, that whenever we invest our money in expectation of future returns, there is always a chance that those expectations can be belied. That is what is the risk involved with any investment, that is, the fact that our actual return can differ from our expected return is the risk. If the actual return turns out to be more than expected, we celebrate and if the reverse happens, we can be found moping.

Therefore, just as we can hope to earn a positive return on our investments, we must also be willing to take a chance that they might turn out to be negative.

We can refuse to take that chance and avoid investing. The good part of that is that our money remains safe but dead. Stagnant money is the bad part. If it does not grow, there is only one thing that can happen with it: it goes on losing value. If you have $100 today and you hide them under a mattress, you will find that a year later, their actual worth will be less than a $100.

It follows that our willingness to tolerate a certain degree of risk, translates into a possibility of earning a positive return and the more risk you can bear, the more return you expect to earn. Put differently, if you have to be persuaded to take on some risk, you are going to ask for a suitable return for it. Risk and return go hand in hand.

In this post, I am focusing on how to find out the return and risk if we invest in a single asset (which, of course is not as wise as investing in more than one asset). The videos below demonstrate this simple process. The first video deals with return and the second one deals with risk.

Return of a Single Asset





Risk of a Single Asset