Risk return tradeoff is an investing term that describes the relationship between the risk an investor takes and the level of returns he realizes. The two move in tandem: as risk increases, so does the potential for higher returns. Likewise, the less risky an investment is, the lower the returns or rewards are likely to be. Risk return tradeoff is one of the simplest and most basic investing concepts to grasp. It’s important for investors to know what level of risk they’re comfortable accepting and how that can translate to returns when choosing investments.
A financial advisor can match your risk profile with securities that fit your risk profile.
Risk Return Tradeoff Explained
Virtually all investments carry some degree of risk, though some are riskier than others. For example, stocks are generally considered to be much riskier than bonds because they’re more susceptible to market volatility. Understanding differences in risk is central to understanding how the risk return tradeoff works.
In simple terms, the more risk an investor is willing to take on the greater the likelihood of generating higher returns from an investment. So an investor who chooses to concentrate 90% of their portfolio on stocks and 10% on bonds may realize higher returns compared to an investor who only holds 40% of their portfolio in stocks and 60% in bonds.
The tradeoff the first investor makes is accepting a greater possibility of losing money in order to realize higher returns. Meanwhile, the second investor is making a different kind of tradeoff. By concentrating less of their holdings in stocks, they’re exchanging the potential for higher returns for more stability with fixed-income investments.
How to Calculate Risk Return Tradeoff
When considering an investment’s risk profile, there are some basic rules of thumb to keep in mind. For example, it’s generally accepted that stocks are inherently riskier than bonds. Stocks are more vulnerable to market volatility which can send prices up or down very quickly. Bonds, on the other hand, tend to be affected by broader trends, such as changes to interest rate policy.
Mutual funds and exchange-traded funds (ETFs) can help to spread out risk, as you’re investing money in a pool of investments. Within that pool, you may have a mix of stocks and bonds that have varying risk profiles. So if one underperforms or becomes more volatile, you have other investments to balance them out.
When calculating risk return tradeoff for mutual funds, there are some metrics investors can use as a guide. These include:
- Alpha. Alpha is a measurement of a mutual fund’s risk-adjusted returns compared to its underlying benchmark. So if you’re investing in an index fund that tracks the Nasdaq composite index or the Russell 2000, for instance, you’d use that to measure alpha. If the returns outpace the benchmark you have positive alpha; if returns are below the benchmark you have negative alpha. A higher alpha rating suggests the potential for greater returns.
- Beta. Beta measures a mutual fund’s volatility relative to its benchmark. When beta is positive, this means the fund is more volatile than the benchmark. If beta is negative, it’s less volatile. Higher beta (and thus, higher volatility) could lead to higher returns.
- Sharpe ratio. Sharpe ratio measures how a fund performs compared to low-risk or risk-free investment. If a fund has a Sharpe ratio of 1 this means it has the potential to generate a higher rate of return. If the ratio is below 1 this signals that the returns you could generate may not be justified by the level of risk required.
- Standard deviation. Standard deviation compares two things: an investment’s individual return over time and its average return for that same time period. When the standard deviation is higher, that can indicate increased volatility, more risk and possibly higher returns. When the standard deviation is lower, that can suggest lower risk and lower returns.
These four metrics can be used to evaluate the risk for different funds when deciding where to invest. It’s important, however, to remember that risk return tradeoff is not a guarantee of how a particular investment will perform. Taking on greater risk does not mean that you’re certain to reap higher returns It only means you’re comfortable accepting a greater possibility of losing money to potentially get those higher returns.
Using Risk Return Tradeoff to Build a Portfolio
Knowing what risk return tradeoff means can help with deciding what to include in your portfolio. But beyond that, it’s also important to consider other factors, including your time horizon for investing, objectives, risk tolerance and risk capacity. Risk tolerance and risk capacity represent two linked but different concepts. Your risk tolerance is the level of risk you’re willing to accept when making investments. Risk tolerance can be shaped by your age, goals and personal preferences. The spectrum can range from very conservative to moderate to very aggressive, with other degrees of risk tolerance in between.
Risk capacity, on the other hand, represents the level of risk you need to take to achieve your investment goals. So the bigger the goals or the shorter your time horizon, the more risk you may need to take on. That’s important to understand when putting risk return tradeoff to work.
When risk tolerance and risk capacity are aligned, choosing investments may become easier. And you may also be more likely to achieve the level of returns that you’re expecting. On the other hand, if there’s a wide gap between the amount of risk you’re comfortable taking and the amount of risk you need to take, then you may be more likely to fall short of your goals.
Taking a risk tolerance questionnaire can help you get a better sense of how much risk you’re truly comfortable with. But you may also want to talk to a financial advisor about what type of risk capacity is required to meet your goals. This can help you find a middle ground between the two so that you’re better equipped to choose investments that have the best odds of allowing you to reach those goals.
Understanding risk return tradeoff can help with making investment decisions. For example, if you’re seeking higher returns then you know that you’ll probably need to take more risk. And if you prefer to invest more conservatively, you also know that it could mean realizing a lower level of return. Just keep in mind that results are not guaranteed so creating an investment portfolio that’s properly diversified can help with managing risk.
Tips for Investing
- Consider talking to a financial advisor about how to manage risk in your portfolio and what level of risk is appropriate for you to take. If you don’t have a financial advisor yet, finding one doesn’t have to be complicated. SmartAsset’s financial advisor matching tool makes it easy to connect with professional advisors in your local area. It takes just a few minutes to get your personalized advisor recommendations online. If you’re ready, get started now.
- Most retirees cannot get by on their Social Security benefits alone. However, they’re a reliable source of income to help cover living expenses during your later years. Plan ahead with our Social Security calculator to know how much financial support you can expect.
- In addition to your Social Security benefits, a well-funded retirement should have sufficient savings. Look to see if you are on track with our retirement calculator. Although, your savings will only stretch so far according to your lifestyle. Try our cost of living calculator to get a clearer picture of the type of income you’ll need in the future.
Photo credit: ©iStock.com/Marcus Millo, ©iStock.com/SrdjanPav, ©iStock.com/ebstock