This step considers what we mean by a portfolio. In the following steps you will study the return and risk of portfolios in more detail. For illustration we will examine portfolios consisting of only bonds; only stocks; and a combination of bonds and stocks.
You will remember the return on a bond depends on the coupon payments and the repayment of the face value of the bond at maturity, and on how much you pay to purchase the bond to receive those cash flows. The return on a stock is the capital gain (the difference between the price of the stock at the end and start of the holding period), plus dividends (if they are paid), expressed relative to the stock price at the start of the holding period.
You also saw that investment in stocks is relatively more risky than investment in bonds. The cash payments in relation to bonds are fixed (assuming the company remains solvent and does not default on the bond). In contrast, there is no guarantee of future payments in relation to stocks.
Historically, the returns on stocks have been higher than the returns on bonds, if you hold these assets for a long enough period of time. However, one of the reasons for this is that the returns on stocks are more risky, and investors require a higher expected return to compensate them for the increased risk.
A portfolio is a collection of assets. The portfolio could be constructed with a particular objective in mind. You might have an idea of the level of return you would like to achieve from the portfolio. But you would also have an idea of the level of risk you are prepared to accept. Let’s consider three simple examples.
We have said that bonds are relatively less risky than stocks, and that returns on bonds are relatively lower than returns on stocks. If you prefer low-risk investments, then you might construct a portfolio consisting entirely of bonds.
On the other hand, you might prefer to earn a higher return on your investments, and you are prepared to accept relatively higher levels of risk. In this case you could consider a portfolio consisting entirely of stocks.
Bonds and stocks
Finally, you might consider a portfolio consisting of a mixture of bonds and stocks. You like the relatively safe investment provided by bonds, but you would also like some exposure to the relatively higher returns offered by investment in stocks.
The return you can expect to make from the mixed portfolio will depend on the returns on bonds and stocks, and also on the relative sizes of the bond and stock holdings in your portfolio. Likewise, the riskiness of the portfolio will depend on the riskiness of bonds and stocks, and also on the relative importance of bonds and stocks in your portfolio.
Before we begin our analysis of portfolios, please consider briefly the following question. If you were constructing a portfolio of financial assets, would you be more concerned with the level of return, or with the level of risk? Or are your objectives more complex than this question suggests?
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