Risk-return tradeoff is an investment term that describes the relationship between the risk an investor takes and the level of return he realizes. The two move together: as the risk increases, as well as the potential for higher returns. Likewise, the less risky an investment is, the lower the returns or rewards are likely to be. Risk-return balancing is one of the simplest and most basic investment concepts to understand. It is important for investors to know what level of risk they readily accept and how that can translate into returns when choosing investments.
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Risk-Return Balancing Explained
Virtually all investments involve some degree of risk, although some are riskier than others. For example, stocks are generally considered much riskier than bonds because they are more sensitive to market volatility. Understanding differences in risk is essential to understanding how the trade-off between risk and return works.
Simply put, the more risk an investor is willing to take, the more likely they are to get a higher return from an investment. So an investor who chooses to focus 90% of his portfolio on stocks and 10% on bonds can achieve higher returns compared to an investor who only 40% of their portfolio in equities and 60% in bonds.
The trade-off the first investor makes is to accept a greater chance of losing money in order to realize a higher return. Meanwhile, the second investor makes a different kind of trade-off. By concentrating less of their holdings in stocks, they trade the potential for higher returns for greater stability with fixed income investments.
How to calculate the risk-return trade-off
When considering an investment’s risk profile, there are some ground rules to keep in mind. For example, it is generally accepted that stocks are inherently riskier than bonds. Stocks are more vulnerable to market volatility, which can cause prices to move up or down very quickly. Bonds, on the other hand, are often influenced by broader trends, such as changes in interest rate policy.
Mutual funds and exchange-traded funds (ETFs) can help diversify risk as you are investing money in a pool of investments. Within that pool you can have a mix of stocks and bonds with different risk profiles. So if one underperforms or becomes more volatile, you have other investments to balance them out.
When calculating the risk-return tradeoff for mutual funds, there are some metrics that investors can use as a guideline. Of which:
alpha. alpha is a measure of a mutual fund’s risk-adjusted return compared to its underlying benchmark. So if you invest in an index fund that tracks, say, the Nasdaq composite index or the Russell 2000, you would use that to measure alpha. If the return exceeds the benchmark, you have a positive alpha; if the return is below the benchmark, you have negative alpha. A higher alpha rating suggests the potential for higher returns.
beta. beta measures the volatility of a mutual fund relative to its benchmark. When the beta is positive, it means the fund is more volatile than the benchmark. If the beta is negative, it is less volatile. A higher beta (and thus higher volatility) can lead to higher returns.
Sharpe ratio. Sharpe ratio measures how a fund performs compared to low-risk or risk-free investments. If a fund has a Sharpe ratio of 1, it means it has the potential to generate higher returns. If the ratio is less than 1, it indicates that the return you could generate is not justified by the level of risk required.
Standard deviation. Standard deviation compares two things: the individual return of an investment over time and the average return for that same period. When the standard deviation is higher, it can indicate: increased volatility, more risk and possibly a higher return. A lower standard deviation may indicate lower risk and lower return.
These four metrics can be used to evaluate risk for different funds when deciding where to invest. However, it is important to remember that the trade-off between risk and return is no guarantee of how a particular investment will perform. Taking more risk does not mean that you will definitely get a higher return. It just means you’re comfortable with accepting a higher chance of losing money get those higher returns.
Using Risk-Return Balancing to Build a Portfolio
Knowing what the risk-return tradeoff means can help you decide what to include in your portfolio. But beyond that, it’s also important to consider other factors, including your investing time horizon, objectives, risk tolerance and risk capacity. Risk tolerance and risk capacity represent two interrelated but different concepts. Your risk tolerance is the level of risk you are willing to accept when making investments. Risk tolerance can be shaped by your age, goals and personal preferences. The spectrum can range from very conservative to moderate to very aggressive, with other degrees of risk tolerance in between.
Risk capacity, on the other hand, represents the level of risk you must take to achieve your investment goals. So the bigger the goals or the shorter your time horizon, the more risk you may have to take. That’s important to understand when you’re putting the risk/return tradeoff to work.
When risk tolerance and risk capacity are aligned, choosing investments can become easier. And you’re also more likely to get the expected returns. On the other hand, if there’s a big gap between the amount of risk you’re willing to take and the amount of risk you should take, you’re more likely to miss your goals.
Taking a risk tolerance questionnaire can help you get a better sense of the risk you’re really comfortable with. But you may also want to talk to a financial advisor about the kind of risk capacity needed to achieve your goals. This can help you find a middle ground between the two, so you’re better equipped to choose investments that offer the best chance of achieving those goals.
Understanding the trade-off between risk and return can help you make investment decisions. For example, if you’re looking for a higher return, you know that you probably need to take more risk. And if you prefer to invest more conservatively, you also know that this can mean lower returns. Please note that results are not guaranteed, so creating an investment portfolio that is well diversified can help manage risk.
Tips for investing
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