What is Risk/Return Trade-off?

In the world of investments, risk is often directly proportional to potential return. This means that the higher the risk, higher the chances of potential returns, and lower the risk, lower the potential returns. To achieve the desired return, you must be willing to take a certain amount of risk.

What is the trade-off about?

The risk-return trade-off looks at balancing the lowest risk you can take with the highest best return you can achieve with that risk. It is essentially a trade-off that you, as an investor, face when choosing the level of risk and the potential return associated with it. Investors use risk-return trade-off as one of the essential components of each investment decision, as well as to assess their portfolios as a whole.

At the portfolio level, risk-return trade-off can include assessments of the concentration or the diversity of holdings, and whether the mix presents too much risk or a lower-than-desired potential for returns. However, it should be noted that high risk does not always ensure high returns. Risk means that there is a chance of incurring a loss on investments as well.

Investing wisely entails investing based on your risk tolerance and risk appetite. The terms risk appetite and risk tolerance are often used interchangeably. However, they represent different concepts. Risk appetite is the desired level of risk that you can take in pursuit of your financial goals. Risk tolerance reflects the variation in returns that you are willing to tolerate.

Understanding the trade-off from an investors point of view

When an investor is planning to make new investments, they should always consider the risk-return trade-off and assess whether the expected returns of the investment are worth the associated risk. For example, if an investor invests in a bank Fixed Deposit (FD) with a lock in of 5 years, it might fetch a 6.5% annual return on investment. On the other hand, investing in a NIFTY 50 Index fund (a type of mutual fund) may yield approximately 12% annual return based on past 20 years’ performance of the NIFTY 50 index.

Although, the investment made in NIFTY 50 Index fund is a stock market investment and carries market risks. Thus, while the investment has nearly double returns, it is subject to market volatility and isn’t insured like in the case of bank FD. Bank FD has the risk of bank defaulting, but its occurrence is fairly rare. Also investments up to ₹5 Lakhs are insured by the government under the DICGC scheme. In conclusion, investors need to consider various factors and decide whether they are comfortable with safer investments with lower returns or if they want to pursue higher returns by taking on some level of risk.

Risk appetite and tolerance depend on your investment goals, age, income and psychological comfort with the level of potential loss you may be able to take.

Conclusion

Taking on some risk is imperative when it comes to generating returns. While it is impossible to eliminate all risk, one can invest wisely to generate returns while still enjoying peace of mind.

Past performance may or may not be sustained in future The information contained in this document is for general purposes only and not an investment advice. Readers should seek professional advice before taking any investment related decisions.

MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS. READ ALL SCHEME RELATED DOCUMENTS CAREFULLY.