4) Risk and Diversification: The Risk-Reward Tradeoff
The iron stomach test is synonymous to the risk-return tradeoff. An important investment decision that must be made is on deciding the amount of risk you can take on.
The ratio is the balance that an investor has to take between the desire for the lowest possible risk that would yield the highest possible returns.
The risk-free rate of return is represented by the quoted yield of the “U.S. Government Securities” because the government seldom defaults on loans. For example, suppose the risk-free rate is 6%. You can earn 6% per annum on your investment with virtually no risk at all. But, if the index funds are averaging 12-15% per year, would you want to earn only 6%? However, index funds return only -5% one year, 25% the next year, and so on, and not 15% the whole time. Simply put, for one to receive a higher return, investors would need to assume more risk.