Introduction
The potential returns on investment often go hand in hand with the level of risk an investor is willing to take. Risk Return Trade Off tells us about the relationship between these two factors. It implies that as the potential returns increase, the level of risk an investor is taking does too. Let’s understand what this principle means, what factors affect it, and how you can evaluate it.
What is Risk Return Trade Off?
In investing, the risk return trade off is a principle that describes the relationship between risk and returns. Also known as the risk reward spectrum, the relationship states that as the potential returns on an investment increase, so does the risk associated with it. So what is risk return trade off? In simple terms, it implies that if you want to earn higher profits, you’ll have to take on higher risk and face the possibility of losing money. On the other hand, if you want to earn a risk-free return, you’ll have to settle for lower profits.
Here’s an example to help you understand this principle better. Everyone knows that investing in stocks and equity mutual funds comes with risks, whereas vehicles like fixed deposits and government bonds offer near-guaranteed returns. While the risk-free options offer only modest returns, is it not true that equities offer the possibility of much bigger rewards? This is the basis of this concept – The risk taken tends to scale up alongside the potential for higher returns.
Why is the Risk Return Trade Off Important?
The risk return trade off is a key factor investors consider in every investment decision. Stocks and equity mutual funds offer much higher potential for wealth creation over the long term. The risk-free options, while good for preserving wealth, generally cannot make a significant contribution to growing it. This is because their returns are often too modest to outpace inflation. Thus, every investor has to consider their risk tolerance before making a decision.
Let’s take another example to highlight the importance of risk return trade off. Suppose two individuals – Rahul in his early 20s and Ajay in his early 50s, decide to invest for their retirement.
Rahul is just starting his career so he may not have a significant investible surplus. He does, however, have a long investment horizon which gives him the ability to take on higher risks. The larger time frame can thus allow him to invest a big portion of his portfolio in stocks or equity mutual funds. Even though these instruments are volatile in the short term, they have the potential for substantial long-term growth. On the other hand, the older individual, Ajay, has a much shorter time frame before retirement and that generally means he does not have the luxury of recovering from short-term market downturns. For him, a conservative approach would be more suitable, which includes investing in low-risk options like bonds and debt mutual funds to preserve his capital while earning steady returns.
In this case, even though both Rahul and Ajay want to invest for retirement, there is a difference in their goals. Rahul’s objective is to grow his wealth, whereas, for Ajay, the priority is to preserve what he has already accumulated. Rahul’s investment horizon allows him to pursue an aggressive strategy, while Ajay’s age prohibits him from taking an aggressive approach. Ajay can still consider investing in equities to achieve some growth, but he has to carefully evaluate whether the potential rewards justify the risks at his stage in life.
Another way the risk return trade off relationship helps investors is through diversification. To diversify one’s portfolio means to spread investments across a variety of asset classes and sectors to reduce overall risk. It’s unlikely that every stock in one’s portfolio performs well. Some will incur losses, which is what diversification offsets. It reduces the impact of poor performance in any single investment on one’s portfolio. This is one of the most essential principles of investing, though it can also dilute returns.
Suppose in a portfolio of just 4 or 5 small-cap stocks, every single one performs exceptionally well. In such a case, the portfolio would experience tremendous growth. On the other hand, due to a lack of diversification, this concentrated portfolio is also highly vulnerable to risk. If even one or two of these stocks were to perform poorly, it could have a devastating impact on the portfolio’s performance. So while a concentrated portfolio can potentially earn very attractive returns, it also comes with extremely high levels of risk. This is simply the risk return trade off on display.
Key Factors Influencing Risk Return Trade Off
For an investor, the level of risk return trade off depends on factors like:
1. Risk tolerance
Based on risk tolerance, investors are broadly divided into three categories – Aggressive, moderate, and conservative investors. Aggressive are those who are willing to take on high levels of risk to potentially earn higher rewards. Conservative investors value safety more, so they are content earning lower returns. Moderate investors look to balance risk and returns. But what category an investor falls under does not only depend on their preference. It also takes into account the investor’s age, financial responsibility and stability, goals, and more. For example, an investor with a higher investible surplus and fewer immediate financial obligations would generally lean toward an aggressive strategy. Contrarily, an individual with many financial responsibilities, such as family obligations or loan repayments, would gravitate toward a conservative approach.
2. Investment horizon and the ability to replace lost funds
Let’s reflect again on the previous example with Rahul and Ajay. Rahul’s age allowed him to invest for longer, giving him a much wider investment horizon. This consequently allowed him to invest heavily in assets like equity mutual funds and stocks which are volatile in the short term but rewarding over time. Ajay, on the other hand, took a more conservative approach as he had a shorter time frame. In other words, he had less time to recover from potential losses.
Examples of Risk Return Trade Off
Generally speaking, investments tend to follow a particular risk return trade off progression, which means they follow a path in either an increasing or decreasing order of risk and potential return. Here’s an example of risk return trade off progression: government bonds, corporate bonds, debt mutual funds, hybrid mutual funds, and equity mutual funds. Lower-risk investments like government bonds are associated with lower returns, while higher-risk investments like equity mutual funds offer higher potential returns.
This is just a broad progression. One can see the risk return trade off within an asset class as well. For example, the progression for mutual funds with equity components goes something like this:
Equity-oriented hybrid funds (like balanced advantage funds and aggressive hybrid funds)< Large-cap funds< Large and Mid-cap funds< Flexi-cap funds< Multi-cap funds< Focused funds< Mid-cap funds< Small-cap funds< Sectoral funds.
From this progression, we can understand that as far as equity-oriented funds go, hybrid funds with equity components (like balanced advantage funds) are on a relatively lower risk profile compared to pure equity funds like small-cap and sectoral funds. This is because the former type also invests in debt instruments, which makes it less risky. As you move through the progression, the level of equity exposure and risk increases. According to the risk return trade off principle, this implies that funds on the higher end of the spectrum have the potential to offer much higher returns.
Risk Return Trade Off in Portfolio Management
Let’s have a look at how the risk return trade off relationship works in a portfolio:
Asset Allocation
Different types of assets have different levels of risk associated with them. Government bonds are safe and offer low returns. Debt mutual funds carry slightly higher risk but also offer relatively (and potentially) higher returns. Hybrid funds add in the element of equity so the risk and return increase again. Finally, stocks and equity-oriented mutual funds have high returns and risk levels.
A diversified portfolio will contain a mix of such assets. Asset allocation refers to how we divide these assets in the portfolio. For example, a portfolio with 85% resources allocated to equity and 15% to debt indicates that the investor is quite aggressive and is taking on high risk for potentially higher rewards.
To increase the risk return trade off the investor can change the allocation by selling debt instruments and buying more equity. Similarly, if the investor wants a more moderate approach, they can reduce the risk return trade off by bringing the asset allocation down to 50% equity and 50% debt. This allocation can be adjusted as per the investor’s financial goals, risk tolerance, and investment horizon.
Diversification
A diversified portfolio can reduce risk. How diversified or concentrated a portfolio is can also give us insights into an investor’s risk profile. For example, a well-diversified stock portfolio across different market caps and sectors means the investor minimises the risk that comes with putting all eggs in one basket. The investor can increase the risk return trade off by concentrating the portfolio. By having only a handful of stocks across specific industries, the investor is inviting an incredible amount of risk, but at the same time, the potential rewards can be huge.
Rebalancing Portfolios
Over time due to changes in the market values of securities, a portfolio’s original asset allocation can shift. This can alter an investor’s risk-return profile. For example, if the investor’s stocks perform well while their bonds remain steady, the portfolio will become weighted toward stocks. This means the original asset allocation changed and the resources dedicated to stocks increased, and so did the risk involved.
How to Evaluate the Risk Return Trade Off?
Here are a few ways one can calculate the risk return trade off:
1. Alpha
Alpha is used to calculate how much excess return an investment earned relative to its benchmark. For example, if a fund’s alpha is +3, it suggests that the fund earned 3% higher returns compared to the benchmark. Similarly, an alpha of -1 means the fund was unable to match its benchmark by 1%.
Suppose you invest in a large-cap fund. These funds are actively managed by a fund manager and charge higher fees compared to index funds. The fund manager aims to earn returns higher than the large-cap benchmark, so due to the active management style, the risk associated with them is also slightly higher than index funds. If the fund has a positive alpha, that means the manager successfully outperformed the benchmark. If the alpha is negative, then the fund underperformed.
By investing in a large-cap fund over a fund that simply tracks the large-cap index, you’re taking on extra risk with the hope of earning higher returns. You are basically accepting the risk return trade off – That there is potential for higher returns by taking on the added risk of active management, but it comes with the possibility that the higher fees and management may not justify the extra risk.
2. Beta
Investors use Beta when they want to evaluate how an investment responds to a benchmark determining the overall market movement. It simply measures how much market risk an investment carries relative to the overall market. Beta has a baseline of 1. Here’s how it works:
- When Beta = 1: It suggests that the investment moves in line with the market. For example, if there’s a 3% rise in a benchmark, the investment with Beta 1 will also rise by 3%. A 5% fall in the benchmark would mean the investment falls by 5%. As you can guess, since index funds track a benchmark’s movements, their Beta is 1.
- When the Beta is less than 1: It indicates that the investment is stable and less volatile than the market. If the market moves up or down by 5%, the investment will move by less than 5% in the corresponding direction.
- When the Beta is greater than 1: It indicates that the investment is more volatile than the market. If the market moves by 10%, the investment can either move up 10% or down 10%.
3. Risk-adjusted Returns
Risk-adjusted returns, like the Sharpe, Sortinio, and Treynor Ratios can also give you valuable information about the risk return trade off of an investment. These ratios measure the excess return (return above the risk-free rate) earned by an investment relative to the level of risk taken. They basically tell you whether or not the risk you’re taking is worth the reward. For example, the Sharpe ratio is calculated by:
Sharpe Ratio = (Return on investment – Risk-free return) / Total standard deviation
The risk-free return relates to the return on an investment that is considered free from any risk, like government bonds. As you can see from the formula, the extra return is compared directly with risk (total standard deviation). So a higher Sharpe ratio is preferred when comparing investment, as it indicates that a healthy return was earned compared to the risk taken to achieve it.
Sortino and Treynor ratios also measure excess returns against risk, albeit a bit differently. In place of the total standard deviation in the Sharpe ratio formula, the Sortino ratio considers only the downside standard deviation. Similarly, the Treynor ratio compares excess return against Beta.
Investors can use Alpha, Beta, and various risk-adjusted ratios to gain different insights about a particular investment’s risk return trade off.
Conclusion
Risk Return Trade Off is an investing principle according to which returns are proportional to the level of risk an investor takes. In a nutshell, the potential for generating more returns increases when more risk is taken.
A very important thing to note here is the word ‘potential’. The risk return trade off principle does not state that returns increase with risk, but rather that there is a potential for higher returns as the level of risk rises. An investor might achieve higher returns investing in high-risk securities, but there is no guarantee that they will. That’s why investors should carefully analyse exactly how much risk they can afford to take, taking into account factors like age, comfort with risk, investment horizon, and the ability to recoup losses. Chasing returns without taking risk tolerance into account can turn ugly quickly if things don’t go as planned.
Investors should also regularly monitor their portfolios to make sure that the level of risk remains aligned with their goals and risk tolerance. Metrics such as alpha, beta, and Sharpe ratio can help you calculate the risk return trade off associated with your investments. In the end, you should always match your risk profile and financial goals with your investments. Taking on more risk would only make sense if the financial goal demands it and the investor can afford it.