The risk-return tradeoff states that the potential return rises with an increase in risk. Using this principle, individuals associate low levels of uncertainty with low potential returns, and high levels of uncertainty or risk with high potential returns. According to the risk-return tradeoff, invested money can render higher profits only if the investor will accept a higher possibility of losses.
The risk-return tradeoff is the trading principle that links high risk with high reward. The appropriate risk-return tradeoff depends on a variety of factors including an investor’s risk tolerance, the investor’s years to retirement and the potential to replace lost funds. Time also plays an essential role in determining a portfolio with the appropriate levels of risk and reward. For example, if an investor has the ability to invest in equities over the long term, that provides the investor with the potential to recover from the risks of bear markets and participate in bull markets, while if an investor can only invest in a short time frame, the same equities have a higher risk proposition.
Investors use the risk-return tradeoff as one of the essential components of each investment decision, as well as to assess their portfolios as a whole. At the portfolio level, the risk-return tradeoff 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.
A canny investor delves into the fundamentals of a prospective investment to gain insights into the actual amount of risk associated with it. If this investor perceives that the actual risk level differs from the general perception, then this difference can be exploited to achieve above-average returns.
Risk-return trade-off in mutual funds
Mutual funds returns vary considerably between small-cap funds, mid-cap funds, large-cap funds, hybrid funds, debt funds etc and so does the risk. Small-cap equity funds have the highest level of risk, while debt funds are known to be relatively safer. Higher level of risk in small-cap funds can deliver higher returns as compared to low-risk debt funds.
However, a higher level of risk doesn’t guarantee higher returns. While high-risk investment options do have higher returns potential, there’s always uncertainty and can deliver significant losses too.
Alpha measures the risk-adjusted returns of a mutual fund scheme against its underlying benchmark. If a mutual fund follows Nifty 50, the risk-adjusted returns of the fund above or below the performance of the benchmark are considered alpha. For instance, a negative alpha of 1 means that the mutual fund underperformed in comparison to its benchmark by 1%. A positive alpha indicates better performance than the benchmark. The higher the alpha is, the higher is the returns potential.
Beta measures the volatility of the fund according to the benchmark. A higher or positive beta means that the fund is more volatile as compared to its benchmark. Funds have lower or negative beta if their volatility is lower than the benchmark.
Funds with lower betas are highly recommended to new investors as they are less volatile. But less volatility often leads to lower returns as compared to a fund with a higher beta. However, higher beta does not guarantee higher returns.
Sharpe Ratio is used for analysing the risk-adjusted returns potential of a mutual fund scheme. In other words, it measures the potential returns of a scheme against each unit of risk the scheme has undertaken.
So, the Sharpe Ratio of 1 means that the returns potential of a fund is higher than what is expected for an investment at a particular risk level. If the ratio is below 1, it signifies that the returns potential of the fund is lower than the risk carried by the fund.
Standard deviation measures the individual returns of an investment over time against its average return for the same period. So, a higher standard deviation means that the fund is volatile and carries a higher level of risk as compared to a fund with a lower standard deviation.
The standard deviation of a fund is compared against the standard deviation of funds from the same category to evaluate volatility and risk.