Question

Keeping the risk return trade off in mind, which of the following investments is clearly preferred over the others for a risk averse investor?

                                                                  

Investment		Mean return		Standard Deviation
A		18%		20%
B		20%		20%
C		20%		22%

Answer 1

According to the risk-return tradeoff, expected return increases with an increase in risk (standard deviation of the return).

In this example, we will compare different pairs and establish which investment should be preferred for a risk-averse investor.

Between investments B and C, clearly, B should be preferred over C as the return on C is against the risk-return tradeoff. C has a greater risk (22%) compared to B (20%) but the return on both these investments are equal (20%). [According to risk-return tradeoff return on C should be higher, but this is not the case here]. So, B should be preferred over C.

Now we will compare investments A and B. Both the investments have the same risk (20%). However, the return on investment B (20%) is greater than that of A (18%). Hence, B should be preferred over A also.

From the above analysis, it is clear that B should be preferred over others as it offers higher expected return at lesser risk.