Risk-Return Tradeoff – Concept, Investments, Measurement & more

Know everything about Risk-Return Tradeoff here. Higher returns are an attention-grabbing segment of the trading sector, beyond doubt.

But, investing without considering the risk associated with it will be one of the stupidest things that you’ll be doing.

Before getting into a simple or complex trading environment, Trading experts remember to take a glimpse of risks related to investment in a particular company.

The ignorance of this little thing later becomes a worse experience of life, typically with amateur traders.

Still, professional traders find risky investments an excellent opportunity to enjoy the high return.

Therefore, to better understand the whole concept, how to do the amalgamation of risk and return stake across the entire trading market, you need to understand the Risk Return tradeoff right over here.

What is Risk-Return Tradeoff?

Traders believe that Risk Tradeoff is like a chief principle of investment, which indicates if there is a higher probability of risk, there will be a higher probability of return.

However, in most instances, a higher return isn’t guaranteed from risky investments.

On the contrary, the principle also states, if the risk associated with a particular investment is low, the potential return value will also be lower.

Altogether, the Risk-Return Trade-Off is a simple message to the trader. If he wants to achieve significant returns, he’ll have to be ready to invest in a risky market.

He’ll have to accept the entire possibilities of losses if his target is big. But no investment indeed comes at a zero level of risk.

The amount of risk can vary significantly between two investments, and it’s impossible that investment has zero risks associated with it.

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Higher Risk vs Lower Risk Investments

Let’s talk about the riskiest investment options. These are equity stocks where investors put their full money with the expectations that this investment will provide them a higher return (more than 10%-12% return per year), which happens.

But throughout the investment plan, these investors are entirely aware of the risk associated with it. The primary reason is trust.

Few companies are so reputed and operational for a long time that they are proficient in winning the investors’ confidence; that’s why investors initiate investments despite playing in a risky environment.

On the other hand, if we talk about one of the less riskiest investments, it’s FDs (Fixed deposit).

Typical Indian families find it the best investment option because they want to generate income from their saved money without taking any risk.

FDs provide them with the easiest way to enjoy a 6% to 7% return annually.

Risk-Return Tradeoff in Mutual Funds

Even though you’re planning to invest your saved money in mutual funds, you’ll observe that differences in returns, such as returns of small-cap funds, large-cap funds, mid-cap funds, debt funds, or hybrid funds, vary considerably.

Like ‘returns,’ ‘the risk’ in mutual funds also varies. For instance, small-cap equity funds can provide you with the highest returns at higher risk.

On the other hand, debt funds can offer you the lowest return at the lowest risk.

It’s worth knowing that despite the investment with a higher level of risk promising higher returns, it still tends to bite off a big chunk of your money within one shot.

That’s why investors often encounter confusion while deciding the best suit for investments.

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How is the Risk Measured?

In the trading world, investors bring a plethora of techniques into action to identify the potential risk related to investment in a particular industry.

However, if we talk about the most straightforward way to determine the risk probability, so it’s the standard method that looks at the market’s volatility thoroughly, what’s the tendency of a particular investment’s value that often slopes upward and downward in price.

If you consider it from a statistical perspective, you’ll find it somewhat similar to the method of standard deviation.

Let’s have a glance at what the standard deviation method represents. The standard deviation primarily measures the dispersion, such as how it affects the data set, in terms of means or averages.

In the example below, we’ve two investments (A and B) indicating returns over the past years.

If you glance at Investment A, you’ll observe a higher return (6% vs. 4%), including standard deviation (6.6% vs. 2.2%).

It’s making investment A slightly risky as compared to Investment B. However, you can also find the variability in both investments, where investment A has higher variability than investment B with low variability.

Let’s understand this discrepancy through further example. In the charts below, you can discover how both investments A and B look like.

You can see that investment A indicates more probability of higher return in the left chart, which is greater than the Investment B in the right chart.

Special Considerations in Risk-Return Trade-Off

Important things to know related to risk return tradeoff –

Measuring Singular Risk in Context

When an investor is willing to invest the amount in high-risk investments, he/she can apply the risk-return tradeoff within the portfolio’s context as a whole or on a singular basis.

If we glance at the examples, equities are high-risk-return investments. However, to reduce the probability of risk, an investor can take help from Diversified Portfolio, which reduces the risk potential.

Risk-Return Tradeoff at the Portfolio Level

The risk-return tradeoff can be seen at the portfolio level. For instance- a portfolio consists of all-equities, on the one hand, showcases higher return potentials, but we can’t overlook the higher risk potential.

In the all-equity portfolio, both reward and risk can be increased by concentrating investments within specific sectors.

Conclusion – Risk-Return Tradeoff

After taking an in-depth overview of the risk-return tradeoff, now you are ready to be called smart investors.

However, the tradeoff is typically applied to all kinds of investments irrespective of a specific one.

That’s why, rather than any strategy, investors try to give more of their time to creating an effective investment portfolio after taking the potential risk and reward into consideration.

One should try to build a portfolio following varying risk and returns levels to stay balanced.

Also, make sure that you set your investment objective, and your portfolio should match your investment profile.

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