What is the Risk-return Trade-off And How is it Calculated?
As an investor, you must know more than the basics to become a savvy investor. To advance in your investment journey, you need to understand advanced concepts such as risk-return trade-offs.
The return of investment is of prime importance for every investor. But, while generating higher returns, investors fail to consider the risks involved. The returns of any investment in a financial market is directly related to its risk factor. This phenomenon is known as risk-return trade-off.
What is the risk-return trade-off?
Every type of investment is associated with some risk, which can significantly vary between two options. For instance, equity stocks have one of the highest levels of risks in the financial markets i.e. they also have the highest returns potential. If you have selected quality stocks, they can generate more than 10%-12% returns annually.
Risk Return Trade off Definition
On the other hand, investment options such as bank FDs come with minimum risk with annual returns around the range of 6%-7%. Every type of investment, equity, mutual funds, bullion market, or even real estate, this relationship between risk and returns is prevalent everywhere.
So, every investor must consider the risk-return trade-off at the time of selecting an investment to meet their goals
Risk-return trade-off in mutual funds
Mutual funds returns vary considerably between small-cap funds, mid-cap funds, large-cap funds, hybrid funds, debt funds etc and so does the risk. Small-cap equity funds have the highest level of risk, while debt funds are known to be relatively safer. Higher level of risk in small-cap funds can deliver higher returns as compared to low-risk debt funds.
However, a higher level of risk doesn't guarantee higher returns. While high-risk investment options do have higher returns potential, there's always uncertainty and can deliver significant losses too.
How is the Risk-Return Trade-Off Calculated?
Generally, the risk and return trade-off are calculated with the help of a few metrics. 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. If a 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 better performance than the benchmark. The higher the alpha is, the higher is the returns potential.
Beta
Beta measures the volatility of the fund according to the benchmark. A higher or positive beta means that the fund 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 a higher beta. However, 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, the 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 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 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 evaluate volatility and risk.
Risk-Return Trade-Off and Portfolio Creation
While the trade-off applies to every type of investment, investors emphasise more on it at the time of portfolio making
One should vary risk levels, investments and returns potential to build a well-balanced portfolio and protect against market volatilities. Focus on your investment objective, risk appetite, and investment horizon so that the risk-return trade-off of your portfolio perfectly matches your investment profile.