Risk Return Trade off

The returns potential of an investment option is of prime importance for every investor. But, while every investor would want to generate the highest possible returns, the quantum of risks involved is often overlooked.

The inherent nature of financial markets, irrespective of the type of investment you select, is such that the returns potential of the investment is directly linked to its risk. This phenomenon is known as risk-return trade-off.

The risk-return tradeoff states that the potential return rises with an increase in risk. Using this principle, individuals associate low levels of uncertainty with low potential returns, and high levels of uncertainty or risk with high potential returns. According to the risk-return tradeoff, invested money can render higher profits only if the investor will accept a higher possibility of losses.

Risk-Return Trade-Off Calculation

Generally, the risk and return trade-off are calculated with the help of a few metrics. For instance, in the case of mutual funds, investors determine the trade-off with the help of these metrics-

Alpha

Alpha measures the risk-adjusted returns of a mutual fund scheme against its underlying benchmark. For instance, if a particular mutual fund follows Nifty 50, the risk-adjusted returns of the fund above or below the performance of the benchmark are considered alpha.

For instance, a negative alpha of 1 means that the mutual fund underperformed in comparison to its benchmark by 1%. A positive alpha indicates that the fund outperformed its benchmark. Higher the alpha is, the higher is the returns potential of the mutual fund.

Beta

Beta measures the volatility of the fund in line with its underlying benchmark. Higher or positive beta means that the fund you have selected is more volatile as compared to its benchmark. Funds have lower or negative beta if their volatility is lower than the benchmark.

Funds with lower betas are highly recommended to new investors as they are less volatile. But less volatility often leads to lower returns as compared to a fund with higher beta. But higher beta does not guarantee higher returns.

Sharpe Ratio

Sharpe Ratio is used for analysing the risk-adjusted returns potential of a mutual fund scheme. In other words, it measures the potential returns of a scheme against each unit of risk the scheme has undertaken.

So, Sharpe Ratio of 1 means that the returns potential of a fund is higher than what is expected for an investment at a particular risk level. If the ratio is below 1, it signifies that the returns potential of the fund is lower than the quantum of risk carried by the fund.

Standard Deviation

Standard deviation measures the individual returns of an investment over time against its average return for the same period. So, a higher standard deviation of a mutual fund scheme means that the fund is volatile and carries a higher level of risk as compared to a fund with a lower standard deviation.

The standard deviation of a fund is compared against the standard deviation of funds from the same category to understand how volatile and risky a particular fund is.

The risk-return tradeoff is the trading principle that links high risk with high reward. The appropriate risk-return tradeoff depends on a variety of factors including an investor’s risk tolerance, the investor’s years to retirement and the potential to replace lost funds. Time also plays an essential role in determining a portfolio with the appropriate levels of risk and reward. For example, if an investor has the ability to invest in equities over the long term, that provides the investor with the potential to recover from the risks of bear markets and participate in bull markets, while if an investor can only invest in a short time frame, the same equities have a higher risk proposition.

Investors use the risk-return tradeoff as one of the essential components of each investment decision, as well as to assess their portfolios as a whole. At the portfolio level, the risk-return tradeoff can include assessments of the concentration or the diversity of holdings and whether the mix presents too much risk or a lower-than-desired potential for returns.

Measuring Singular Risk in Context

When an investor considers high-risk-high-return investments, the investor can apply the risk-return tradeoff to the vehicle on a singular basis as well as within the context of the portfolio as a whole. Examples of high-risk-high return investments include options, penny stocks and leveraged exchange-traded funds (ETFs). Generally speaking, a diversified portfolio reduces the risks presented by individual investment positions. For example, a penny stock position may have a high risk on a singular basis, but if it is the only position of its kind in a larger portfolio, the risk incurred by holding the stock is minimal.

Risk-Return Tradeoff at the Portfolio Level

That said, the risk-return tradeoff also exists at the portfolio level. For example, a portfolio composed of all equities presents both higher risk and higher potential returns. Within an all-equity portfolio, risk and reward can be increased by concentrating investments in specific sectors or by taking on single positions that represent a large percentage of holdings. For investors, assessing the cumulative risk-return tradeoff of all positions can provide insight on whether a portfolio assumes enough risk to achieve long-term return objectives or if the risk levels are too high with the existing mix of holdings.

Risk-Return Trade-Off in Mutual Funds

Even if you want to invest in mutual funds, you will see that the returns vary considerably between small-cap funds, mid-cap funds, large-cap funds, hybrid funds, debt funds, and others. Just like the returns, the quantum of risk varies too.

Small-cap equity funds have the highest level of risk, while debt funds are known to be relatively safer. But, the higher level of risk in small-cap funds can also deliver higher returns as compared to low-risk debt funds.

However, it is worth noting that a higher level of risk in no way guarantees higher returns. While high-risk investment options do have higher returns potential, this potential should never be confused with any guarantee. High-risk investments could very well deliver significant losses too.