Take a good look at this chart.
It is a portfolio consisting of only 2 assets: stock and bond.
Here are some interesting points:
1. 100% in Stock
This portfolio has the highest risk and also probability of the highest return.
2. 100% in Bond
This portfolio has low risk (NOTE: NOT THE LOWEST) and has lower return.
3. 50% in Stock and 50% in Bond
This portfolio has the same risk as and has higher return than the portfolio that is 100% in Bond.
4. 25% in Stock and 75% in Bond
This portfolio has the lowest risk and has higher return than the portfolio that is 100% in Bond.
(You may assume that holding cash giving an interest rate of 3% is the equivalent of holding a bond with a coupon rate of 3%.)
Holding 100% in bond carries the same risk as holding 50% in stock and 50% in bond. However, the probability of a higher return for the same risk should make investors favour holding 50% in stock and 50% in bondthan to hold 100% in bond.
For those who are very risk averse, for example in the present falling market, the lowest risk is the portfolio that is 25% stock and 75% bond, and not the portfolio that is 100% in bond. Moreover, the portfolio that is 25% stock and 75% bond, offers a probability of higher return for lower risk, that the portfolio with 100% in bond.