Trade-off
Conducting a sensitivity analysis, a money manager can combine various asset classes, calculate the historical risk and rates of return of each combination, and create a so called "optimal" combination or portfolio, one which offers the highest expected rate of return for a given level of risk. Below is a basic example of how this works:
| Security A has an average return of 6% and a standard deviation (risk) of 3.2 | Security B has an average return of 12% and a standard deviation (risk) of 7.8 |
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With a conglomerate of both, the investor gets a return of 9% with a standard deviation (risk) of 3.7.
READ MORE: To better understand this principle, we look at an investment curve...