The term “risk return trade off” refers to the connection between an investor’s level of risk tolerance and the level of returns he realizes. So, the possibility for higher returns rises as the risk increases and vice versa. If an investment involves fewer risks, the rewards/returns will probably be lower.
One of the most fundamental and straightforward concepts in investing is the risk return trade-off. When selecting investments, it’s critical for investors to understand the level of risk they are comfortable taking and how that can affect returns.
Here, you’ll learn what risk return trade-off is about, examples, and how it is calculated.
What is Risk Return Trade Off?
Risk return trade off asserts that, as risk increases, so does the potential return. Based on this principle, people associate low levels of uncertainty with low potential returns and high levels of risk/uncertainty with large potential returns.
The risk-return trade off states that invested money can only result in higher rewards only if the investor will tolerate a higher possibility of losses.
Risk Return Trade Off Explained
Though certain investments are riskier than others, almost all investments involve some level of risk. For instance, because stocks are more subject to market volatility than bonds, they are often regarded as being riskier. To comprehend how the risk return trade off works, it is essential to understand how different risks vary.
Simply put, the more risk an investor is willing to accept, the higher the chance of reaping larger returns from an investment. Therefore, an investor who decides to concentrate 90% of his portfolio on stocks and 10% on bonds may have higher returns, unlike an investor who concentrates only 40% of their portfolio on stocks and 60% on bonds.
The trade off the first investor makes is agreeing to a larger possibility of losing money in exchange for higher returns. Whereas, the second investor is making another type of trade off. They trade the possibility of larger returns for more stability with fixed-income assets by focusing fewer of their holdings on stocks.
How to Calculate Risk Return Trade Off
There are several fundamental guidelines to follow when considering the risk profile of an investment. For instance, it is widely accepted that equities carry more inherent risk than bonds.
Stock prices can move swiftly up or down due to market volatility. On the other hand, bonds are frequently affected by broader trends, such as adjustments to interest rate policy.
As you invest money in a pool of investments, exchange-traded funds (ETFs) and mutual funds can help spread out risk. You may blend stocks and bonds with various risk profiles within that pool. Therefore have other investments to balance them out if one doesn’t perform well or becomes more volatile.
When calculating the mutual funds risk return trade off, investors can use some metrics as a guide. Here’s how to calculate risk return trade off:
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Alpha
Compared to its underlying benchmark, alpha is a measurement of the risk-adjusted returns of a mutual fund scheme. A scheme with zero alpha has produced returns that are the same as the benchmark.
If a scheme has a negative alpha, it means the benchmark performance of the fund has been below average. On the flip side, a scheme with a positive alpha performs better than its benchmark. Therefore, the potential returns increase as the alpha increases.
Alpha = (Mutual Fund Return – Risk Free Return (Rf)) – [(Benchmark Return – Risk Free Return (Rf)) * Beta]
Simply put, alpha helps in determining the possible returns the mutual fund investment can generate. Despite the fact that a higher alpha implies higher returns, it is not the only metric used to assess the performance of a fund.
Beta
Beta is the measurement of a mutual fund’s volatility regarding dynamic market changes. Simply put, this metric measures how sensitive a mutual fund portfolio is to changes in the market. Beta helps in comprehending how the fund responds to changes in the market.
Additionally, the market’s or the benchmark’s beta is always one. When compared to its benchmark index, a fund’s beta value lesser than one suggests lower volatility. Meanwhile, a fund with a beta higher than one shows greater volatility than its benchmark.
Beta = (Mutual Fund Return – Risk Free Rate (Rf)) / (Benchmark Return – Risk Free Rate (Rf))
Depending on the beta value, you can choose whether to include a mutual fund in your portfolio. Funds with a beta of less than one are less volatile and should be chosen by novice or risk-averse investors. Risk-takers can also choose funds with higher beta. But, higher beta does not ensure high returns because it does not reveal the fund’s absolute or inherent risk.
Sharpe ratio is a performance metric that helps you determine the potential of the risk-adjusted returns of a mutual fund scheme. Risk-adjusted returns show the return that a mutual fund scheme provides over and beyond the risk-free rate of return. In a nutshell, the Sharpe ratio helps in estimating the possible returns a scheme can generate for each unit of risk it takes on.
The greater the ratio, the better the return potential compared to the risk. A greater Sharpe ratio means that a fund’s return potential at a given risk level is higher than expected. Similarly, a negative Sharpe ratio indicates that a fund’s returns potential is lower than its level of risk.
Share Ratio = (Mutual Fund Returns – Risk Free Rate) / Standard Deviation
Additionally, the Sharpe ratio takes into consideration the investment’s inherent risk (standard deviation). To determine whether the fund can produce returns that are higher than the risk-free rate, you can analyze its risk.
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Standard Deviation
Standard deviation allows you to measure how much a portfolio’s return deviates from its average. In simple terms, a mutual fund’s standard deviation shows how far its performance deviates from expected returns.
A higher standard deviation shows greater volatility and entails a higher risk level than one with a lower standard deviation. Standard deviation, as opposed to just market-related volatility, evaluates overall risk.
Standard deviation can be used as a performance metric to compare two funds belonging to the same category. Without comparing the standard deviation to other funds in the same category, you cannot tell whether it is high or low.
You can use these aforementioned metrics to calculate risk return trade off for various funds when considering where to invest. However, you must keep in mind that risk return trade-off does not guarantee how a specific investment will perform.
Accepting higher risks doesn’t guarantee that you’ll surely reap higher returns, it simply means you’re willing to accept a higher possibility of losing money to potentially reap those higher returns.
Conclusion
It’s easier to make investment decisions when you understand risk return trade off. For instance, if you want higher returns, it means that you’ll have to take more risks. And if you’d like to invest conservatively, keep in mind that you could reap a lower return level. However, an investment portfolio can assist with handling risk.
FAQs
In general, the higher the risk, the higher the potential return of investment. You’re not guaranteed to reap a higher return by accepting more risk.
You measure risk by the difference between the actual returns and expected returns. This otherwise means the amount of volatility.
The following information must be considered for risk and return; earnings, earnings growth, inflation, stock buybacks, dividend growth, currency values, etc. Additionally, the risk spectrum can help with guiding your decisions.
The risk return trade off states that the potential return to be earned from an investment should rise as the risk level rises. What this means is that investors are unlikely to pay a higher price for investments with a low level of risk, such as top government or corporate bonds.
The knowledge of risk return trade off is very important as it helps you make the right decisions. It assists you in choosing the right investment option keeping in mind how much risk you’re willing to accept. In addition, it helps you filter out fraudulent investment proposals.
References
- smartasset.com – What Does Risk Return Tradeoff Tell Investors?
- investopedia.com – Risk-Return Tradeoff
- scripbox.com – Risk Return Trade Off
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