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What is Risk-Return Trade-Off and How It Is Calculated?

Risk Return Trade Off

As an investor, you must know a lot more than just the basics to become a savvy investor. To advance towards the next level of the investment journey, one needs to understand advanced concepts such as risk-return trade-off. Read this post to know what it is and how it is calculated.

Risk Return Trade off Definition

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.

What is Risk-Return Trade-Off?

Every type of investment comes with a certain level of risk, which can significantly vary between two options. For instance, equity stocks are known to have one of the highest levels of risks in the financial markets. But there is no denying that they also have the highest returns potential. If you have selected quality stocks, they can generate more than 10%-12% returns annually.

On the other hand, investment options such as bank FDs come with minimum risk. But, the annual returns are generally in the range of 6%-7%. And this concept not just applies to the financial markets. Every type of investment, be it 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 so that the risk level is in line with the risk appetite.

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.

How is the Risk-Return Trade-Off Calculated?

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.

Risk-Return Trade-Off and Portfolio Creation

By understanding the risk-return trade-off meaning, you are one step closer to becoming a savvy investor. While the trade-off applies to every type of investment, investors emphasise more on it at the time of creating an investment portfolio.

One should select investments across varying risk levels and returns the potential to build a portfolio that is well-balanced and protected against market volatilities. Do also 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.