Risk Return Trade Off
Risk Return Trade off defines the relation between the potential return from an investment and the risk involved. It states that higher the risk, greater will be the potential return and if an investor is looking for low-risk options than they must also expect lower returns.
What is Risk Return Trade Off
Return on Investment is obviously one important aspect to consider while making investment decisions. While every investor seeks to receive the maximum return from their investment, there is one more aspect which is less discussed but quite important and that’s risk taken while making the investment.
This relationship between these two key aspects of investment is referred to as Risk Return Trade off. The concept is all about investor’s willingness to take the amount of risk to increase the probabilities of higher returns.
Difference between Risk and Return
Every investment contains some ‘risk’, though the intensity of the risk depends on the class of investment.
On the other hand, ‘return’ is what every investor is after. It is the most sought out factor in the financial market.
As per the tradeoff between risk and return, the amount of risk determines the degree of return. If an investor is looking for higher returns, he must invest in the instruments containing higher risk. However, if the risk bearing capacity of the investor is low or they are not looking for high returns, they should invest in the low risk profile instrument.
Investment Risk vs. Return on Investment
The investor must keep in mind that though the risk and return are proportionate to each other, higher risk doesn’t guarantee higher return; it only increases the probability of it.
Hence, an investor looking to get higher returns must be able to have good risk bearing capacity, because without investing in the riskier instrument higher returns cannot be achieved.
Also, one should not only focus on getting the return. To have a balanced combination of risk and return in their portfolio, the investor need to analyze their risk-bearing ability, investment goal, and time duration in which they would like to achieve it.
Risk Return Trade off in Finance
In India’s financial market, people often tend to invest in low risk instruments like government-issued bonds, fixed deposits etc. However, with the growing trend and rise in inflation, people now-a-days are considering to invest for higher returns.
Low risk financial instruments are considered to be of very low risk as they are backed by government and banking institutions. Their non-speculative nature allows them to give low but safer returns. Hence, the return from such instruments is considered to be risk-free.
High risk financial instruments like equity mutual funds are market dependent. They are volatile in nature and highly risky, but they also increase the chances of higher potential return in the long run. Investors who invest in mutual funds expect higher returns because they know that they are investing in riskier financial instruments. Also, it has been observed that between the return from an investment in equity mutual fund for a longer duration and a fixed deposit for the same duration, the former gives the higher return because of the default risk attached to them.
Ideal Investor Portfolio
An ideal investment portfolio must contain investments in both low-risk and high-risk financial instruments with major portion in the latter. Such portfolio provides security of return as well as opens the door for higher potential return.