Risk-Return Tradeoff

Loading the player...

What is the 'Risk-Return Tradeoff'

The risk-return tradeoff is the principle that potential return rises with an increase in risk. Low levels of uncertainty or risk are associated with low potential returns, whereas high levels of uncertainty or risk are associated with high potential returns. According to the risk-return tradeoff, invested money can render higher profits only if the investor is willing to accept the possibility of losses.

BREAKING DOWN 'Risk-Return Tradeoff'

The appropriate risk-return tradeoff depends on a variety of factors including risk tolerance, years to retirement and the potential to replace lost funds. Time can also play an essential role in determining a portfolio with the appropriate levels of risk and reward. For example, the ability to invest in equities over the long-term provides the potential to recover from the risks of bear markets and participate in bull markets, while a short time frame makes equities a higher risk proposition.

For investors, the risk-return tradeoff is one of the essential components of each investment decision as well as in the assessment of portfolios as a whole. At the foundation of this assessment, the consideration of the risk as well as the reward of an investment can determine whether taking action makes sense or not. At the portfolio level, the risk-return tradeoff can include assessments on the concentration or the diversity of holdings and whether the mix presents too much risk or a lower than desired potential for returns.

Measuring Singular Risk in Context

Examples of high risk-high return investments include options, penny stocks and leveraged exchange-traded funds (ETFs). When these types of investments are being considered, the risk-return tradeoff can be applied to the vehicle on a singular basis as well as within the context of the portfolio as a whole. Generally speaking, a diversified portfolio reduces the risks presented by individual positions. For example, a penny stock position may be extremely high risk on a singular basis, but if it is the only position of its kind and represents a small percentage of the portfolio, the overall risk may be minimal.

Portfolio Level Risk

The risk-return tradeoff also exists at the portfolio level. For example, a portfolio composed of all equities presents both higher risk and the potential for higher returns. Within an all-equity portfolio, risk and reward can be increased by concentrations in specific sectors or single positions that represent a large percentage of holdings. Conversely, a portfolio holding short-term Treasury’s presents low risk levels combined with limited returns. For investors, assessing the cumulative risk-return tradeoff of all positions can provide insight on whether a portfolio has assumed enough risk to achieve long-term return objectives or that risk levels are too high with the existing mix of holdings.

RELATED TERMS
  1. Risk Lover

    An investor who is willing to take on additional risk for an ...
  2. Aggressive Growth Fund

    A mutual fund that attempts to achieve the highest capital gains. ...
  3. Portfolio Management

    Portfolio Management is the art and science of making decisions ...
  4. Diworsification

    The process of adding investments to one's portfolio in such ...
  5. Eat Well, Sleep Well

    An adage that, referring to the risk/return trade-off, says that ...
  6. Capital Market Line - CML

    A line used in the capital asset pricing model to illustrate ...
Related Articles
  1. Managing Wealth

    Risk and Diversification: The Risk-Reward Tradeoff

    The risk-return tradeoff could easily be called the iron stomach test. Deciding what amount of risk you can take on is one of the most important investment decision you will make. The risk-return ...
  2. Managing Wealth

    Financial Concepts: The Risk/Return Tradeoff

    The risk/return tradeoff could easily be called the "ability-to-sleep-at-night test." While some people can handle the equivalent of financial skydiving without batting an eye, others are terrified ...
  3. Managing Wealth

    Understanding Risk-Return Tradeoff

    The essence of risk-return tradeoff is embodied in the common phrase “no risk, no reward.”
  4. ETFs & Mutual Funds

    Measuring a Fund's Risk and Return

    Learn the importance of the risk-return relationship in selecting a mutual fund.
  5. ETFs & Mutual Funds

    Perspectives on the Risk-Return Relationship

    By Richard Loth (Contact | Biography)"The history of the stock and bond markets shows that risk and reward are inextricably intertwined. Do not expect high returns without high risk. Do not expect ...
  6. ETFs & Mutual Funds

    Scoring Risk-Return Data

    By Richard Loth (Contact | Biography)This is the entry we need to complete in the Fund Investment Quality Scorecard for an analysis of a fund's risk-return profile: Obviously, ...
  7. Managing Wealth

    Achieving Optimal Asset Allocation

    Minimizing risk while maximizing return with the right mix of securities is the key to achieving your optimal asset allocation.
  8. ETFs & Mutual Funds

    Fund I-Q No.2: Favorable Risk-Return Profile

    By Richard Loth (Contact | Biography)As mentioned previously, a mutual fund's risk-return profile is important for a number of reasons: Common sense tells us that a fund investor should ...
  9. Retirement

    3 Retirement ETFs Suitable for Your Portfolio

    Building a retirement portfolio which is in accordance with your needs as well as risk tolerance is certainly difficult. Suitable ETFs can help with that.
  10. Retirement

    The Money Market

    If your investments in the stock market are keeping you from sleeping at night, it's time to learn about the safer alternatives in the money market.
RELATED FAQS
  1. How can I use risk return tradeoff to determine my risk tolerance and investment ...

    Learn how an investor can use the risk-return tradeoff to determine what assets to include in a portfolio, and understand ... Read Answer >>
  2. Why is risk return tradeoff important in designing a portfolio?

    Learn how the risk return tradeoff is used in the construction of portfolios, and how modern portfolio theory seeks to diversify ... Read Answer >>
  3. What is the breakdown of subjects covered on the Series 6 exam?

    Learn about the risk-return tradeoff for investing in stocks versus low-risk Treasurys and bonds, and understand the types ... Read Answer >>
  4. What are some classes I can take to prepare for the Series 6 exam?

    Learn about how the risk-return tradeoff applies to bond yields, and the different types of risks associated with investing ... Read Answer >>
  5. What metrics should I use to evaluate the risk return tradeoff for a mutual fund?

    Understand the key metrics used to analyze mutual funds and how investors can use each measurement to determine the risk-reward ... Read Answer >>
  6. Is there a positive correlation between risk and return?

    Learn about the positive correlation between risk and the potential for return, and understand how risk is used to construct ... Read Answer >>
Hot Definitions
  1. Duration

    A measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. ...
  2. Dove

    An economic policy advisor who promotes monetary policies that involve the maintenance of low interest rates, believing that ...
  3. Cyclical Stock

    An equity security whose price is affected by ups and downs in the overall economy. Cyclical stocks typically relate to companies ...
  4. Front Running

    The unethical practice of a broker trading an equity based on information from the analyst department before his or her clients ...
  5. After-Hours Trading - AHT

    Trading after regular trading hours on the major exchanges. The increasing popularity of electronic communication networks ...
  6. Omnibus Account

    An account between two futures merchants (brokers). It involves the transaction of individual accounts which are combined ...
Trading Center