Stocks and Bonds: Risk vs. Return

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%.)


Conclusion:

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.