Use of a Risk and Reward Chart

A risk and reward chart is a very useful tool when creating a portfolio and comparing asset classes. Its usefulness is due to its ability to let a user truly visualize how combining various asset classes will help or hinder a portfolio. This articles aim is to help users understand what they are looking at when they view a risk and reward chart. In order accomplish this task we will use two of the riskier asset classes: small cap value and emerging markets.

The left hand side of the chart, the vertex axis, represents the compounded annualized return of a series of portfolios and the horizontal axis represents risk in the form of standard deviation. In the middle of the chart we have a series of points that are connected with a line. Each point represents a different combination of the selected assets to form a total portfolio. In the chart below we have used the two asset classes mentioned above, small cap value and emerging markets.

The very left hand side of the line we have a point which represents a portfolio consisting of 100% SCV. The point is plotted by the portfolios annualized return and its standard deviation. On the right hand side of the line we have a point which represents 100% EM. This point is also plotted by the same standard as the point on the left. All of the points in the middle of the line represent a different combination of the SCV and EM assets. As the points move from left to right we slowly move from 100% SCV to 100% EM in 5% increments.

In the above risk and reward chart you can see point #1, 100% SCV, has the lowest annualized return and a standard deviation of about 20. This means that a portfolio consisting of 100% SCV and no EM has the lowest annualized return and is fairly risky with a standard deviation of 20. Point #2 represents 95% SCV, and 5% EM. This combination has a slightly better annualized return and a slightly lower standard deviation. When we move up to point #10 we have drastically changed the risk and reward relationship. Point #10 represents 55% SCV and 45% EM and shows that a portfolio consisting of this combination would have about the same standard deviation as 100% SCV but a 3% higher return. The final point, #21, is 100% EM. The risk and reward chart shows that a portfolio consisting of 100% EM only has an annualized return of about 1.5% better than point #10 but with much more risk.

Risk and reward charts allow investors to completely visualize how various asset classes react to each other. They are not confined to only comparing two asset classes but can be used to compare whole portfolios. For instance let’s imagine you had a stock portfolio that consisted of: 40% Total Stock Market, 30% SCV, and 30% Total International. If you wanted to add some bonds to this portfolio, to reduce risk, you would use a risk and reward chart. The chart would show you how adding various increments of bonds would reduce risk and annualized return. Hopefully this article helped understand what a risk and reward chart is and how to use it.