Risk and Return Trade-Off in Portfolios
The golden rule of finance: There is no free lunch. If you want higher returns, you must accept higher risk.
Measuring Return
Expected Return of a portfolio is the weighted average of individual asset returns.
E(R_portfolio) = w1 * R1 + w2 * R2 + ... + wn * Rn
Where:
w1, w2, ...= Weights (% invested in each asset)R1, R2, ...= Expected return of each asset
Example:
- 50% in Stock A (Expected Return = 12%)
- 50% in Stock B (Expected Return = 8%)
- Portfolio Return = 0.5 × 12% + 0.5 × 8% = 10%
Measuring Risk
Risk is measured by Variance or Standard Deviation (volatility).
For a portfolio, it's NOT just the weighted average of individual variances. It also depends on Covariance (how assets move together).
Portfolio Variance = w1^2 * σ1^2 + w2^2 * σ2^2 + 2 * w1 * w2 * Cov(R1, R2)
Key Insight: The third term 2 × w1 × w2 × Cov(R1, R2) is the diversification benefit. If Covariance is negative, portfolio risk is LESS than the weighted average of individual risks.
The Trade-Off
Risk-Return Profile by Asset Class
Low Risk / Low Return
- Cash / FDs: 5-6% Return, Very Low Risk.
- Govt Bonds: 7-8% Return, Low Risk.
- Corp Bonds: 8-10% Return, Moderate Risk.
High Risk / High Return
- Large Cap Stocks: 12-15% Return, High Risk.
- Small Cap Stocks: 15-20% Return, Very High Risk.
- Crypto/Startups: >20% Return, Extreme Risk.
Risk-Free Rate
The Risk-Free Rate is the return you get with zero risk (e.g., Government Treasury Bills). In India, it's around 6-7%.
Any investment with risk should offer a return above the risk-free rate. The extra return is called the Risk Premium.
Test Your Knowledge
Question 1 of 5
1. Portfolio return is calculated as: