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The Risk and Return on Stock and Bonds

Explain the historical relationships between risk and return for common stocks versus corporate bonds. Explain the manner in which diversification helps risk reduction in the portfolio. Support the response with actual data.

Usually, the higher the risk on an asset, the greater the return or potential for loss. Take stocks for instance, stocks have high growth potential, but its price changes considerably during the year. Volatility is a term used to describe this occurrence and is a risk factor that must be considered when making investments. For example, the average 10-year (after inflation) 70/30 portfolio (bond) is approximately 47%. An individual who is closer to retirement may choose to invest less in stocks because he or she cannot afford to take the risk. On the other hand, younger investors have more time and can deal more effectively with market fluctuations.

Another consideration is when a person invests in a government bond that pays a certain percentage of yield over a specific number of years (e.g., 2% yield for ten years), and the investor gets a return on his or her principal. In this scenario, there is less risk, with less reward. As a rule of thumb, an investor's portfolio should include risky and less risky investments. The investor should also invest in a variety of asset classes that show little correlation with each other (e.g., no movement, up and down in lockstep).

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You are definitely on point when you say the greater the risk, the greater the return. And yes, common stock returns are generally higher than corporate bonds. Primarily because corporate bond risk depends on the financial health of the corporation offering the bond. For example, if the company goes into a bankruptcy state, it's possible that it won't have the funds to repay the bond value or any return of that matter. Therefore, it's always good to check with ...

Solution Summary

This post is geared towards the pros and cons of investing in corporate stock or bonds.