An investor can choose between Asset A (expected return 4%, low volatility) and Asset B (expected return 10%, high volatility). Which statement best describes the risk-return tradeoff?
AAsset B is strictly better because it has a higher expected return
BAsset A is strictly better because it avoids the risk of loss
CAsset B's higher expected return compensates for the possibility of larger losses; the right choice depends on the investor's time horizon and risk tolerance
DThe two assets are equivalent because diversifying between them averages out to 7%
The risk-return tradeoff means neither asset is universally 'better.' Asset B's higher expected return is compensation for accepting the possibility of larger losses. An investor with a long time horizon can weather downturns; one needing funds soon cannot. Option D conflates the concept of diversification with expected return averaging — blending assets changes the volatility profile, not just the midpoint return.
Question 2 True / False
Owning five different mutual funds automatically provides meaningful diversification.
TTrue
FFalse
Answer: False
Diversification benefit comes from holding assets whose returns are not perfectly correlated — when one falls, others don't fall equally. Five large-cap U.S. equity funds from different providers may hold many of the same underlying stocks and move nearly in lockstep. True diversification requires assets that respond differently to the same economic events (e.g., combining equities with bonds, international stocks, or real assets).
Question 3 Short Answer
Why does a longer investment time horizon generally allow an investor to accept more risk?
Think about your answer, then reveal below.
Model answer: A longer horizon gives the portfolio time to recover from downturns. Short-term volatility becomes less relevant when the investor won't need to liquidate assets for decades; historically, diversified equity portfolios have recovered from all major crashes given enough time.
Risk in investments shows up as volatility — short-term prices can swing dramatically. But if an investor has 30 years before needing the money, they can ride out a 40% crash and benefit from the subsequent recovery. An investor who needs money in two years cannot afford to wait for a recovery, so they must hold lower-volatility assets even if expected returns are lower.