While investing or planning for investment, we often come across two terms, risk and return. Risk is the possibility of fetching unexpected lower returns or incurring losses from an investment. Returns are the profit or earnings from an investment.
When we combine these two terms in the investment context, we get the risk-return trade-off. So, what is the risk-return trade-off? Let’s understand this concept and how to calculate it.
What is the risk and the risk/return tradeoff?
Risk return tradeoff is used in investment parlance to describe the relationship between the risk of an investment versus the returns that it can fetch. These two factors are correlated since if there’s a higher risk, the chances of returns are also higher. Similarly, the lower the risk of an investment, the lower the returns from it.
For example, if Investor A’s portfolio comprises 90% of stocks and only 10% of debt investments, he/she may be able to earn higher returns as compared to Investor B who has invested only 40% of his corpus in stocks and the remaining in debt instruments.
To put this example in a risk-return tradeoff context, the risk-return tradeoff that Investor A accepts is taking on a higher risk of losing money to earn higher returns. Investor B, however, prefers to gain lower exposure in stocks since he/she prefers stability through debt investments and is willing to let go of the chances of making higher returns.
How do you calculate Risk-Return trade-off?
To calculate the risk-return trade-off, we need to use some metrics. Mutual fund investors can estimate the trade-off by using the following:
This metric is used to measure the risk-adjusted returns of a mutual fund scheme vis-à-vis a chosen benchmark. For example, if a mutual fund’s benchmark is the Nifty 50 index, its risk-adjusted returns that are more or less than the benchmark’s performance are called alpha.
To put it simply:
- An alpha of -1 means – the mutual fund has underperformed by 1% versus Nifty50.
- An alpha of +1 means – the mutual fund has outperformed Nifty50 by 1%.
Thus, the higher the alpha, the better will be the investment’s returns potential.
Beta is used to check a fund’s performance volatility against a benchmark. This is how Beta is used to interpret a fund’s performance:
- A positive beta means a mutual fund is more volatile vis-a-vis its benchmark.
- A negative beta means lower performance volatility as compared to the benchmark.
Therefore, investors must invest in funds with lower betas since they are less volatile. However, it is important to note that less volatility could mean lower returns versus a fund that has a higher beta. Higher beta, on the other hand, does not always mean higher returns.
Sharpe ratio is used to measure the potential of a mutual fund scheme to deliver risk-adjusted returns. Simply put, it tells us how much returns a scheme can potentially fetch against every unit of risk that an investor undertakes while investing in it.
Here is how it can be interpreted:
- Sharpe Ratio of 1 indicates a returns potential higher than what an investment at a given risk level earns.
- A ratio below 1 means lower returns potential than the risk associated with the fund.
Standard deviation helps in measuring the individual returns from an investment generated over a period against its average returns during the same time period.
It can be interpreted as:
- A higher standard deviation indicates volatility in fund returns with a higher risk
- A fund with a lower standard deviation offers lower returns volatility and lower risk
To evaluate the risk-return tradeoff using this metric, the standard deviation of a fund must be compared against other funds within the same category.
Read more : How to use the mutual fund risk-o-meter?
Importance of Risk Return Trade-Off in Mutual Funds
The concept of risk-return is especially critical in mutual fund investments. The importance of the risk-return trade-offs in mutual funds is highlighted below.
- Risk management
Mutual funds (whether they are equity funds, debt funds, or hybrid funds) are subject to various types of risks, including market risk, interest rate risk, credit risk, and liquidity risk. By diversifying portfolios across different asset classes and securities, mutual funds can reduce these risks and provide investors with a more stable return profile.
- Maximising returns
The primary goal of most mutual funds is to maximize their returns for the investors. The risk-return trade-off is a crucial consideration in achieving this goal. Funds generating higher returns also usually have correspondingly higher risks. By finding the right balance between risk and return, mutual funds can help investors maximize their returns while managing the overall risks.
- Meeting investor expectations
Different investors have different investment objectives and risk tolerances. Mutual funds offer a wide range of investment options that have varied risk levels. This helps the investors in meeting their financial goals and objectives with tangible expectations.
Using risk-return trade-off in portfolio creation
Risk-return trade-off can be used in every type of investment and is not restricted to mutual funds alone. Investors can use this concept, especially at the time of portfolio creation.
To create a well-balanced portfolio, it is important to ensure different risk levels and returns potential in investments included in the portfolio This can help in protecting the portfolio against market volatilities. While using the concept of risk-return trade-off, investors must focus on factors like financial goals, risk appetite, and investment time period to enhance their decision-making.
Before making an investment, investors must carefully analyse the level of risk that they’re willing to accept and how it impacts the returns that the investment can earn them.
Most investment avenues come with a certain degree of risk, some may be higher and some may be lower. For instance, equity investments are generally riskier than debt investments since the latter is more susceptible to market volatility.
To build a well-diversified portfolio, an investor must ensure the right balance between risk and returns. This is achievable by including a mix of investments such as equity, debt, real estate, cash, etc in a portfolio.
An ideal portfolio mix should comprise equity, debt, and other alternative investments in a proportion that is suitable to the investor’s risk-return expectations.
In a 60/40 portfolio approach, 60% of the corpus is allocated to long-term investments such as stocks and index instruments and the remaining 40% is set aside for debt instruments like bonds. This allows a good risk-return trade-off.
At different stages of life, one can have different financial priorities. Therefore, it is important to reshuffle one’s investment portfolio from time to time and adjust it as per the latest priorities and goals. Rebalancing the portfolio is also needed to adapt to changing risk and return needs.