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Answer :
The expected return of a portfolio is calculated using the weighted average of its constituents. Safety is linked to lower volatility, while risk is associated with higher potential losses. A balanced investment strategy, including stocks and bonds, can provide consistent average returns.
The expected return of a portfolio can be calculated by the weighted average of the expected returns of the individual investments, taking into account the percentage of the total investment each stock represents. To find the expected value for each investment, we assign probabilities to the different returns each can generate and calculate a weighted average. In general, an investment is considered safer if it has less volatility and less probability of loss. Conversely, an investment is riskier if the potential for loss is higher. Typically, the investment with the highest average return is also accompanied by higher risk due to increased volatility.
For example, if we consider the investment options from LibreTexts™, we can create a Probability Distribution Function (PDF) for each investment to assess their expected values and risks. The safest investments tend to have lower expected returns and lower volatility, while the riskiest might offer higher potential profits but also a greater chance of substantial loss.
Therefore, the strategy for constructing a diversified portfolio would involve a mix of assets that would offer a balance between risk and return, such as the traditional mutual fund composed of both stocks and bonds, aiming to achieve consistent average returns and minimize risk.
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