Risk management: Introducing portfolios

This article considers what we mean by a portfolio.

What is a portfolio?

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.

All bonds

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.

All stocks

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.

Returns on bonds and 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.

Returns on a bond

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 the start of the holding period), plus dividends (if they are paid), expressed relative to the stock price at the start of the holding period.

Investment in stocks is relatively riskier than investing 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 riskier, and investors require a higher expected return to compensate them for the increased risk.