What is Risk-Return Tradeoff?
Every investment has some risk associated with it. Therefore, understanding the Risk vs Return Correlation is essential for every investor. Relation between Risk and Return is probabilistic. High risk may give you high returns but the probability of that high returns depends upon the investment option. Risk can be managed by Time Frame, Diversification, Your Risk Tolerance Level and Knowledge.
Every Investment Has A Risk Attached
- Investing can be a highly effective way to grow your money and build a foundation for a good financial life.
- It’s also important to be aware that investing is not a risk-free strategy and there’s always a chance you could lose money or not make as much as you expected. However, not taking any risk is not the solution or will not help your investments grow. “The biggest risk is not taking any risk”.
- All investments carry some risk due to factors such as inflation, tax, economic downturns and market factors. The volatility associated with Financial market is nothing but the Market Risk. While investing, risk is measured to evaluate the kind of returns you should expect from the investment. Or your return expectations should be based on the level of risk that you can bear.
- Different types of investments carry different levels of investment risk and also different returns. You might be thinking – How can debt be risky..?? Well, it is.
- Companies that run into financial trouble could delay your interest payments or even default on paying back your money. It is called as Credit Risk. IL&FS is one of the recent example. Even government debt has some amount of risk. However, lack of funds for a company could result in the company defaulting on a loan repayment but a government can always print more currency and repay its borrowings. So you will get your money back.
- But, there is a hidden cost (risk). Printing more currency is likely to lead to higher inflation and hence lower real returns on your investment. Agreed that the chances of governments or well-managed companies getting into serious financial troubles are low. But that is only difference in the level of risk. There is a risk attached and that cannot be questioned.
What is Risk vs Return Tradeoff?
- What we call Risk is, actually variability of Returns. An investment with a high variability doesn’t always deliver High Returns. Variability means that it can deliver Low or Negative Returns. A Low-Risk Investment can generate returns that are Higher, than a High-Risk one. That’s part and parcel of risk.
- The connection between high returns and high risk is probabilistic. The chances are that high returns come with a higher risk but that’s it – it’s a chance, a higher probability, that’s all as shown in graph above.
- An investment that has the chance of a higher return is likely to have higher risk. However, the reverse is not true. High risk by itself does not mean higher returns. There are plenty of investments that have a high risk but no chance of high returns. There is a very high risk in lottery, but negligible chance of return.
Why Risk vs Return Tradeoff is Essential for good Financial Planning?
- You might ask – why is it so important to understand the risk versus return relationship? Because if you don’t understand this, it is quite likely that your investment returns will not match your risk profile and consequently you are not managing your hard-earned money well.
- A wasted opportunity, as even a small difference in your investment returns (at the same level of risk) can make a BIG difference to your financial wealth (due to the astounding Power of Compounding). For details and better understanding, refer our article – ‘Power of Compounding’.
Managing Investment Risk
While taking on any kind of risk can be a scary prospect, there are four key strategies you can use to minimize your exposure to investment risk:
- Time-Frame: The longer you stay invested, the less investment risk you are exposed to because fluctuations in the value of your investment will even out over time.
- Tolerance: If you are not comfortable with a certain type of investment, or a certain level of risk, it’s not worth investing in that product.
- Diversification: Diversification allows investors to reduce the overall risk associated with their portfolio but may limit potential returns. Spreading your money across different types of investments rather than relying on one asset class is called as Diversification. It may help shield you from drops in particular markets and deliver more consistent returns over time.
- Knowledge: The more you understand about investments and financial markets, the better you’ll become at selecting investments that are appropriate for you.
- The whole idea behind investment approach is to evaluate the risk associated with various type of investments and take steps so as to balance it with the desired return.
- At the end of the day, as an investor who is putting money into equity-based funds and perhaps even in equity, you must be aware of the sources of risks, your tolerance to them and how the risks can be mitigated.
- The biggest pay-off of handling risk is that you won’t sell off and run away when the markets decline. That alone can severely impact your returns.