The oldest trick in the investment book


The oldest rule in the financial book is that risk and return are related. If you want a higher expected return, you have to take on more risk. If you want to lower risk, you can only do so at the cost of expected return.

Though I always like to specify that the volatility or variability of a portfolio is not necessarily risk to a lifetime investor, in order to objectively evaluate the risk level of investment portfolios for research purposes, variability of portfolio returns is what is used. If you want a higher expected return, you have to accept more variability in your portfolio. If you want less variability, it will cost you as far as expected return.

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Enter Markowitz, who showed in his research that by building a portfolio of investments that are not perfectly positively correlated (a fancy way of saying they behave differently from one another), an investor could actually lower portfolio variability without sacrificing expected return. No wonder diversification is known as the only free lunch in finance; you actually receive the benefit of lower portfolio variability without giving anything up.

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