Risk, Return and Diversification – Getting the Trade-Off Right

The core idea: no free lunch

In investing, there is no way to get high returns with zero risk. If an investment promises unusually high returns with no downside, that is usually a red flag, not a hidden gem.

Over long periods, risk and return move together:

• Assets with higher expected returns tend to have larger short-term swings.
• Assets with more stable prices usually grow more slowly.

Your job as an investor is not to eliminate risk, but to choose the mix of risks that makes sense for your goals and temperament, then diversify so no single holding can do too much damage.

Our Investing 101 page gives a big-picture overview. Here, we zoom in on how risk and return work together.

Different types of risk

“Risk” is not just one thing. A few key flavours matter for most portfolios:

• Market risk: the risk that the entire market (stocks, bonds, or both) moves down together. This is hard to diversify away.
• Company-specific risk: the risk that one particular stock runs into trouble due to poor management, competition or bad luck.
• Interest-rate risk: the risk that changes in interest rates cause bond prices to move, often down when rates rise.
• Credit risk: the risk that a bond issuer cannot meet its payment obligations.
• Inflation risk: the risk that your money does not grow fast enough to keep up with rising prices.
• Liquidity risk: the risk that you cannot easily sell an investment at a fair price when you need to.

When you diversify, you are mainly trying to reduce company-specific risk and smooth out some of the bumps from individual holdings. You cannot fully remove market and inflation risk, but you can choose how much exposure to take.

Where investment returns come from

Over time, investment returns come from a few basic sources:

• Cash flows: interest, dividends and other income paid out along the way.
• Growth: companies growing their earnings; economies expanding over time.
• Valuation changes: how much investors are willing to pay per dollar of earnings or cash flow.

For example:

• Stocks combine growth in company profits with dividends and shifting valuations. See What Are Stocks? for more context.
• Bonds combine interest payments with changes in yields. We cover this on Bond Investing Basics.
• Funds and ETFs are just packaged combinations of these same sources.

Understanding where returns come from helps you set realistic expectations and avoid products that rely purely on marketing language instead of clear economic drivers.

Diversification basics

Diversification means not being overly dependent on any single investment. Instead of putting all of your money in one stock or bond, you spread it across many holdings, sectors and even countries.

At a practical level, diversification can mean:

• Owning broad stock-market and bond-market funds instead of just a few names.
• Mixing assets that respond differently to economic shocks.
• Holding investments across more than one region or currency.

On FTMarketWatch, you can see diversification in action in examples on Investing 101, as well as when we compare funds on Mutual Funds Basics and ETF Basics.

Asset allocation and risk levels

Asset allocation is the big-picture decision of how much of your portfolio to put into different asset classes – typically stocks, bonds and cash. It is one of the most important drivers of your long-term experience.

A simple way to think about it:

• More stocks = higher expected return, higher volatility.
• More bonds and cash = more stability, lower expected return.

Here is a rough illustration of how different mixes might behave. These are not guarantees, but they show the trade-offs:

You can implement these allocations with just a few diversified funds or ETFs. Our pages on Bond Investing Basics and ETF Basics show how to choose building blocks.

Correlation: why different things together help

Correlation measures how closely two investments tend to move together. If they always move in the same direction at the same time, they have high positive correlation. If they often move in opposite directions, their correlation is low or negative.

Diversification works best when you combine assets with imperfect correlation. They might all fall in a severe crisis, but they do not typically move in lockstep day to day.

For example:

• Stocks in different sectors or countries.
• Stocks and high-quality bonds.
• Equities plus a modest allocation to real assets or alternatives.

You do not need to calculate correlation matrices yourself. Using broad funds across different markets usually provides enough diversification for most individual investors.

Simple risk/return examples

Consider two very simplified portfolios for a long-term investor:

• Portfolio A: 100% broad stock-market ETF.
• Portfolio B: 70% broad stock-market ETF, 30% high-quality bond ETF.

Over a 25-year horizon, Portfolio A might produce higher average returns, but also deeper and more frequent drawdowns. Portfolio B sacrifices some upside but tends to have smoother performance. For many people, the smoother path of Portfolio B makes it easier to stay invested during rough periods – which can matter more than the theoretical extra return of Portfolio A.

Behavioural risk: the most underestimated one

Most investment theory focuses on market and asset-level risks. In practice, one of the biggest risks is how we react to market moves. Common behavioural pitfalls include:

• Selling in panic after a sharp drop, locking in losses.
• Chasing hot investments after big rallies.
• Changing strategies frequently based on headlines.
• Checking portfolios so often that every wiggle feels urgent.

A realistic risk/return balance helps you avoid these traps. If your portfolio matches your risk tolerance, you are less likely to abandon your plan at exactly the wrong time.

Common mistakes to avoid

• All-or-nothing bets: going all-in on one stock, sector or commodity.
• Piling into what just went up: assuming recent winners will keep winning indefinitely.
• Ignoring inflation: sitting entirely in cash for long-term goals.
• Overcomplicating portfolios: holding too many funds without a clear reason.
• Confusing volatility with risk: treating any short-term swing as a disaster.

Mini case study: adjusting risk to sleep at night

Taylor is 45 and has been investing aggressively with almost 100% in stocks. During a market downturn, their portfolio falls by more than 25% in a year. Taylor finds it difficult to sleep and considers selling everything.

Instead of abandoning investing, Taylor:

1. Steps back and reviews their goals and time horizon.
2. Reduces the stock allocation to 70% and adds 30% in high-quality bonds.
3. Commits to rebalancing once a year instead of reacting to daily news.

The portfolio still moves with markets, but the swings are smaller. Taylor finds it easier to stay invested, which may ultimately matter more than squeezing out a bit of extra return with a more aggressive mix.

Quick glossary

Risk

The chance that an investment’s actual results differ from what you expect, including the possibility of loss.

Return

The gain or loss on an investment over a period of time, including price changes and income.

Diversification

Spreading investments across multiple holdings so that no single position dominates results.

Asset allocation

The mix of asset classes (stocks, bonds, cash and others) in a portfolio.

Correlation

A measure of how closely two investments tend to move together.

Risk, return and diversification – FAQs

How do I know if my portfolio is too risky?

A simple test: imagine your portfolio dropping 20–30% over a year. If that scenario would likely make you sell everything, your current mix may be too aggressive. Your allocation should match both your time horizon and your emotional comfort.

Can diversification completely eliminate risk?

No. Diversification reduces the impact of individual losers but cannot remove broad market or economic risk. There will still be periods when most investments decline together.

How often should I change my asset allocation?

For most long-term investors, asset allocation changes are driven by life events (such as nearing retirement) rather than market forecasts. Rebalancing once or twice a year to your existing targets is often enough.

Where should I go next on FTMarketWatch?

To connect these ideas to practical tools, explore: Investing 101, ETF Basics, Bond Investing Basics and Retirement Investing Basics. Together, they show how to turn the risk/return trade-off into a clear, durable plan.