Why might investors buy financial assets which do not have the highest rates of return?

Question

BlackTom AI · Accepted Answer

Diversification and the risk–return tradeoff explain why investors often choose assets that do not have the highest nominal return.

1) Relevant knowledge points and concepts
- Risk–return tradeoff: higher expected return typically requires taking more risk. Rational investors maximize expected utility, not just raw return.
- Diversification (portfolio theory): combining assets that are not perfectly correlated can lower portfolio variance (risk) for a given expected return.
- International diversification reduces country‑specific (idiosyncratic) risk.
- Investors consider risk-adjusted returns (e.g., Sharpe ratio), liquidity, taxes, and transaction costs, not only absolute return.

2) Step‑by‑step reasoning
- An investor compares expected returns and associated risks. A single asset with highest expected return may have much higher volatility.
- By including lower‑return assets that are less correlated with the rest of the portfolio, overall portfolio variance falls and risk‑adjusted return can improve.
- Therefore an investor rationally prefers a diversified mix rather than the single highest‑return asset.

3) Example calculation (intermediate steps shown)
- Asset A: expected return 10%, σA = 15% (0.15). Asset B: expected return 8%, σB = 20% (0.20). Correlation ρ = 0.2.
- Portfolio weights wA = wB = 0.5. Expected return = 0.5·10% + 0.5·8% = 9%.
- Covariance = ρ·σA·σB = 0.2·0.15·0.20 = 0.006.
- Portfolio variance = wA^2σA^2 + wB^2σB^2 + 2wAwB·Cov
 = 0.25·0.0225 + 0.25·0.04 + 2·0.25·0.006
 = 0.005625 + 0.01 + 0.003 = 0.018625.
- Portfolio standard deviation ≈ sqrt(0.018625) ≈ 13.65%, lower than σA or σB while expected return (9%) lies between the two.

4) Why the correct answer is correct
- The option “to diversify by buying different types of assets from different countries” captures the reason: diversification reduces risk and can improve risk‑adjusted performance even if the nominal return is lower.

5) Why other options are incorrect
- “Irrationality”: assumes investors act irrationally; many choose lower nominal returns rationally because they value lower risk.
- “They are uninformed”: while possible for some, this is not the general or primary explanation; many informed investors diversify intentionally.
- “All of these”: incorrect because irrationality and uninformed behavior are not the standard rational motives for choosing lower‑return assets.

6) Conclusion
The correct answer is “to diversify by buying different types of assets from different countries,” which matches the provided answer.

Why might investors buy financial assets which do not have the highest rates of return?单项选择题

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