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Risk-return trade-off means that with an increase in the potential return, the risk also increases. Every individual invests in the stock market by following a strategy to achieve short-term or long-term investment goals. Earning profits comes with a set of risks, which every investor has to factor into their strategy.
As per most investors, risk exposure directly affects the profit potential for every investment instrument. They believe that with higher risk comes opportunities for higher profits. Let us understand what is a risk-return trade-off.
What is the risk-return trade-off?
Risk-return trade-off meaning describes the investment mindset of investors for the risk exposure included in their investment strategy. The risk and return trade-off states that when investing in equities and mutual funds, the risk exposure and potential profits move in tandem; the higher the risk, the higher the returns. For example, equities offer the highest potential returns for investors but come with the highest level of risk.
An ideal risk-return trade-off depends on numerous factors such as the set goals, risk tolerance, investment duration and the potential to replace lost funds. If investors want to make high profits in less time, they can follow the risk-return trade-off mindset and invest in volatile assets regularly fluctuating in price.
Understanding risk-return trade-off
Every investment instrument comes with a certain level of risk, where the investors can lose the capital amount owing to various negative factors. However, the level of risk depends on the investment duration, the instrument’s volatility and risk tolerance. Risk-return trade-off is a term used in capital markets by investors who believe that an investment instrument is likely to provide higher returns if it contains a high level of risk. As per the trade-off concept, investing with low levels of risk can provide stable but not high returns.
Investment duration also plays an important role in allowing investors to utilise the risk-return trade-off. Ideally, investing for the long term allows them to potentially lower the risk. However, if one wants to make high profits in the short term, the risk factor is higher with the possibility of higher returns.
Importance of risk-return trade-off in mutual funds
Mutual funds are investment instruments that pool investor money and invest it in various stocks of companies to create a diversified portfolio. They provide investors with different levels of risk and return based on their objectives, risk tolerance, and time horizon, making the risk-return trade-off a vital factor. Here is the importance of the risk-return trade-off in mutual funds.
● Risk management: The trade-off provides a framework to investors for assessing potential risks and rewards for different investment opportunities.
● Return optimisation: Investors can identify investments that offer the best potential return for their level of risk tolerance. This allows them to optimise their portfolio for investment objectives, such as capital preservation, growth, or income.
● Diversification: The risk-return trade-off formula explains the current risk exposure in the investment instruments included in the portfolio. This can allow investors to manage their portfolios and reduce risk by investing in low-risk investment instruments.
Uses of risk-return trade-off
Risk-return trade-off helps investors manage risk, optimise returns, avoid unnecessary losses, and evaluate the performance of their investments. Here are some of the uses of the risk-return trade-off.
● Measuring singular risk in context: Investors can utilise the trade-off when investing in high-return instruments to ensure they choose those with better return potential. Apart from individual securities, investors can also use the risk-return trade-off in the context of their portfolio as a whole to measure and manage the overall risk.
Investors can choose high-risk, high-return investments such as penny stocks, options, etc., to increase their returns potentially, but also ensure that the high-risk investments do not negatively affect the overall portfolio health.
● Risk-return trade-off at the portfolio level: The risk-return trade-off also exists at the portfolio level. The risk-return trade-off example is when an investor has an all-equity portfolio. Since equities contain the highest risk within all asset classes, the portfolio presents high-profit potential but with a high level of risk. With such a portfolio, the investor can use the trade-off analysis to spread the risk across various sectors or mutual funds. The trade-off assessment can provide valuable insights into the possible achievement of the long-term objectives of the portfolio.
How is risk-return trade-off calculated in mutual funds?
The risk-return trade-off in mutual funds is calculated using various tools and metrics that help investors assess the potential risks and returns. Below are some key metrics used to evaluate the risk-return trade-off in mutual funds.
1. Alpha ratio: Mutual fund portfolio investors use the alpha ratio to measure the excess returns on their mutual fund investments. It allows the investors to determine the returns that are more than the benchmark index that the mutual fund follows. A mutual fund benchmark index evaluates the fund's performance relative to a specific market or index.
Its calculation requires the subtraction of the total investment return of the mutual fund from a comparable benchmark of the same asset category. It will have an alpha of -1% if it has underperformed the benchmark by 1%. It will have an alpha of zero if it has neither underperformed nor outperformed the benchmark. The mutual fund t will have an alpha of 1% if it has outperformed the benchmark by 1%.
2. Beta ratio: The beta ratio measures the mutual fund investment’s sensitivity to movements in the market or a particular benchmark index. It determines the volatility of an investment with the overall market. Investors use beta to assess the level of risk associated with their investment. Generally, investors use it to gauge the correlation between the mutual fund units and the benchmarks that determine the overall market, such as NIFTY 50.
Calculating this ratio requires the investors to divide the variance by the co-variance. The variance measures how the market moves relative to the underlying asset (mutual fund units), and co-variance measures the fund’s return relative to the market movement. If the beta is 1% for NIFTY 50, it means it is highly correlated with the benchmark. The mutual fund will have a beta ratio of zero if it is not ideally correlated. Lastly, it will have a beta of -1% if it is inversely correlated with the benchmark.
3. Sharpe ratio: The Sharpe ratio is a measure of risk-adjusted return on investment, and investors use it to calculate the excess return per unit of risk. The Sharpe ratio is calculated by subtracting the risk-free rate of return from the investment's or portfolio's average rate of return and dividing the result by the standard deviation of the returns. The resulting ratio indicates how much excess return an investor receives for the risk taken. Higher the Sharpe ratio, the better the risk-adjusted return.
Is it better to use the alpha, beta, or Sharpe ratio?
While understanding and measuring the risk-return trade-off, investors have three options alpha, beta and Sharpe ratio. These ratios give investors different kinds of information.
The alpha ratio is important for investors who want to calculate the excess return on their Mutual Fund investments. The beta ratio showcases how closely the mutual fund and the benchmark index are correlated. The Sharpe ratio is vital for those who want to understand if their risk is worth the reward or will incur losses.
How is the risk-reward ratio calculated?
The risk-reward ratio is calculated by dividing the expected return of a trade by the amount of invested capital. Traders often aim for a risk-reward ratio of at least 2:1 or higher to ensure that the potential profit outweighs the loss.
Do investments with higher risks yield better returns?
Investments with higher risks do not necessarily yield better returns. As the risk exposure is high, the trade may go sideways, forcing investors to incur huge investment losses. The ideal risk-return trade-off depends on personal investment factors such as the investor’s risk tolerance, the investment duration and the potential to cover the losses.
Investments with higher risk depict a higher level of volatility, which is the main reason for investors to believe that the higher risk can allow them to earn better profits. However, diligence is critical while investing in high-risk securities, which may offer high returns but can result in high losses.
Conclusion
The risk-return trade-off refers to the trade-off between the potential return on investment and the amount of risk involved. Investors can use the three ratios to evaluate the risk-return trade-off in mutual funds and determine whether an investment suits their objectives and risk tolerance. However, it's important to note that these metrics have limitations and should be used in conjunction with other information to make informed decisions. Since the market is dynamic, investors should make use of the risk-return trade-off examples to ensure they manage their risk portfolio effectively for better returns.