The Principle of Risk-Return Trade-Off Explained

The Principle of Risk-Return Trade-Off Explained - Investment, return, rising, clock
Bill Cascade   NEW 25/08/2019 00:00:00 Guides

Many times during trading, you’ll likely come across the principle Risk-Return Trade-Off. A specific trading principle, it may sound straight forward. Yet, this definition is worth looking at in further detail.

Assessing risk is important when considering making any form of investment decision. So, it’s good financial sense to pay further attention to what this principle means. Particularly so because it can affect your financial activity.

Here we investigate the exact meaning behind the term Risk-Return Trade-Off. We also consider examples and what it means to your trading endeavors. Thus, you’re armed with the information you need to trade successfully from thereon.

Defining the Term Risk-Return Trade-Off

In trading terms, the risk-return refers to a financial relationship. It exists when investing. This is between a specific financial market instrument and the potential return expected.

However, it helps to further break it down and understand the principle better. We, therefore, need to develop a clearer definition of the term risk-return trade-off. 

When defined, this is all about the return. So, a higher return is probable when associated with those higher risk trades. Consequently, a smaller return is more likely when those trades are lower in risk.

A commonplace idea, the trade-off element of this can then be better explained. The trade-off is a result of the risk and returns you as an investor will face. This is all while you consider your investment decisions.

Why the Principle of Risk-Return Trade-Off Is so Important

Risk-return Trade-off - scale, questions

Whenever we make any kind of investment decision, we need to ask questions. Our most important question should be, what are we getting in return for this investment?

Besides this question though, there should be another important aspect to consider. So, a second equally important question should exist here. This is that of what is the risk that is being undertaken by making this investment?

When we look carefully at both of these questions, two aspects will stand out. The first is that of risk. The second is that of returns. Instantly we’ve made a connection, or rather a relationship between the two.

So, the relationship between risk and of return becomes clear. It is one better known now as the risk-return trade-off.

It’s so important to ask questions each time before you hand over your money. How much money are you willing to risk to increase your chances of seeing higher returns?

An Example of Risk-Return Trade-Off in Action

There is an ideal way to approach a trading term and further use it to its fullest. All the while, making your own investment decisions helps when you learn by example. Thus, here are a few ways risk-return trade-off works.

Let’s suppose that you wanted to invest and began making a decision. While you’re waiting to make this decision, you inevitably face a risk-return trade-off. Say you decide to deposit a large sum of money into a savings bank account. This will earn a return. That return is the interest rate that is paid by the bank in question. But, this type of investment will earn you a low return. To counterbalance such a low return, you will know your money is insured here. 

Yet, let’s say that you decide to invest in equities instead. You will get the chance to reach those much higher returns this way. These are greater than when compared to that of the returns earned through your bank. Yet, by opting for this choice, you’ll also have to face the possibility of losing a major part of your capital. 

Low Risk Further Explained

Low risk understandably relates to those low-risk financial instruments. The result of most low-risk investments is ultimately a low return. There are many financial instruments considered to be low risk. This is merely because they have the backing of the US federal government. These include Government-issued bonds from US treasuries. 

There is a reason why these bond types have low returns, as opposed to those bonds issued by corporations. This is due to their rather non-speculative nature. This is further emphasized by the return on such government bonds. These are subsequently considered as a risk-free rate. They also offer more to investors in the way of stability. 

High Risk Further Explained

On the other scale to low risk, high risk relates to those assets that many consider being riskier. This is understandable as for the potential return to rise, so too does the risk involved. This relates to those investors who are looking to part with their money.

But, they are doing so for those more perilous of assets. They also instantly demand better returns. These are as opposed to those returns that attract risk-free security. This is because otherwise, they would have no need or reason to take such a risk.

Other instruments such as high yield bonds and equities attract higher return choices here. So these are the assets that encourage investors to assume a higher risk rate. This is despite the possibility of capital loss in the process. 

Examples of Securities and Instruments Offering Risk-Return

Whether low or high, these are some of the more common securities and instruments that offer a risk-return trade-off:

  • Municipal Bonds
  • Government Bonds
  • Corporate Bonds – Investment Grade
  • Corporate Bonds – High Yield
  • Overseas Equities
  • Futures & Options
  • Small-Cap Stocks & Funds
  • Mid Cap Stocks & Funds
  • Blue Chip Stocks & Large Cap Funds

How to Calculate the Required Rate of Return

Risk-return Trade-off - Calculator

For those further interested in the rate of the level of return of any given investment, there is a calculation available. This is a method of calculating the risk premium. It’s a practical means of discerning the level of risk. This allows investors to consider the level of return they’d find attractive enough. And it’s all before parting with their money!

The simple calculation is as follows:

Required Return = Risk-Free Return + Risk Premium

 

What to Be Aware of When It Comes to Risk-Return Trade-Off

As with all trading enterprises, there are many points to consider before utilizing this principle. These include:

  • In every investment type, the risk is inherent. 
  • The scale of an investment’s risk will depend on the instrument selected.
  • For those okay with low return, the investment risk profile will also need to be low.
  • Return is an intangible singularity that is sought after in the financial market. But to increase the higher return possibility, the risk taken must also be increased.
  • The increasing risk will not automatically guarantee a higher return. It works to raise the possibility of it.
  • When seeking a higher return on investment, you’ll need to increase the assumed risk. If not, higher returns will not be possible to achieve
  • There is a way to find a balance between the combination of risk and rewards. This involves understanding your ability to risk take. As well as understanding the aim of your investment. Also, it means considering the time you have available to achieve all this. 

Final Words on the Principle of Risk-Return Trade-Off

To conclude, when assessing the risk-return trade-off, look at your investment time frame. Thus, to those who can invest in equities over the long term – You’ll have a possible time to recover from potential risks. But, to those who can only devote a short time frame to investing – You’ll find that those same equities will present a higher risk element. 

Furthermore, it’s recommended you apply the risk-return trade-off as an essential component. This means in every investment decision you make. This way, you can assess your portfolio as a whole. Then you can decide whether the risk is worth it, whether it’s too risky or too low for any potential for returns. 

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