Risk-return relationship

Risk and return are positively correlated, that is,

The higher the risk, the higher (the potential) return.
The lower the risk, the lower the return.

A principle in finance:
Given a certain level of risk, we want the highest return.
Or, given a certain level of return, we want the lowest risk level.

Each security, each asset class, each investment, has an expected return E(X)
and a historical volatility (sigma).
Risk, in investments, is measured by the volatility of the returns (sigma).

Example :
Equities: (8%, 12%)
Bonds: (6%, 6%)
Real Estate: (20%, 10%), but this asset class is not liquid.
Facebook stock: (10%, 15%)

In Portfolio management, we apply the principle of diversification, that is,

reducing risk by combining different assets in a portfolio.
Reducing risk is achieved because the return on security A and the return on
security B are negatively correlated.
It has been proven that:
The standard deviation of a portfolio depends on three important
determinants:
1. Proportion of each asset in the portfolio.
2. Standard deviation of return of each asset in the portfolio.
3. The correlation of returns between each pair of assets in the portfolio.

Example 1 – Portfolio of 2 Assets

A portfolio combines two assets: X and Y. The proportion of Asset X in the portfolio is 30%, and the 
proportion of Asset Y is 70%. The standard deviation of return of Asset X is 21% and 8% for Asset
Y.
Returns of Asset X and Asset Y are positively correlated as far as the correlation coefficient equals
0.347.

As we can see, the correlation between returns on assets is an important determinant of risk
diversification.