What Is Risk-Return Tradeoff?
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 risk-return tradeoff, invested money can render higher profits only if the investor will accept a higher possibility of losses.
- Risk-return tradeoff is an investment principle that indicates that the higher the risk, the higher the potential reward.
- To calculate an appropriate risk-return tradeoff, investors must consider many factors, including overall risk tolerance, the potential to replace lost funds, and more.
- Investors consider risk-return tradeoff on individual investments and across portfolios when making investment decisions.
Understanding Risk-Return Tradeoff
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 that include 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; on the other hand, if an investor can only invest in a short time frame, the same equities have a higher risk proposition.
Investors use 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, 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.
Uses of Risk-Return Tradeoff
Measuring Singular Risk in Context
When an investor considers high-risk, high-return investments, the investor can apply risk-return tradeoff to the vehicle on a singular basis as well as within the context of the portfolio as a whole. Examples of high-risk, high-return investments include options, penny stocks, and leveraged exchange-traded funds (ETFs). Generally speaking, a diversified portfolio reduces the risks presented by individual investment positions. For example, a penny stock position may have a high risk on a singular basis, but if it is the only position of its kind in a larger portfolio, then the risk incurred by holding the stock is minimal.
Risk-Return Tradeoff at the Portfolio Level
Risk-return tradeoff also exists at the portfolio level. For example, a portfolio composed of all equities presents both higher risk and higher potential returns. Within an all-equity portfolio, risk and reward can be increased by concentrating investments in specific sectors or by taking on single positions that represent a large percentage of holdings. For investors, assessing the cumulative risk-return tradeoff of all positions can provide insight on whether a portfolio assumes enough risk to achieve long-term return objectives or if the risk levels are too high with the existing mix of holdings.
When you want to determine excess returns on an investment, use the alpha ratio, which refers to returns earned on an investment above the benchmark return. In other words, it measures excess returns from the benchmark index.
According to Investopedia, “Alpha, often considered the active return on an investment, gauges the performance of an investment against a market index or benchmark that is considered to represent the market’s movement as a whole.”
To calculate alpha in a simple way, subtract the total return of an investment from a comparable benchmark in its asset category. To take into account asset investments that are not completely similar, calculate alpha using Jensen’s alpha, which uses the capital asset pricing model (CAPM) as the benchmark.
Here’s an example of alpha:
- If a mutual fund has underperformed by 1% against its benchmark, it will have an alpha of -1.0.
- If a mutual fund has neither underperformed nor outperformed, it will have an alpha of zero because it will not have lost or gained value compared to the benchmark index.
- If a mutual fund has outperformed by 1%, it will have an alpha of +1.0.
A beta calculation shows how correlated the stock is vs. a benchmark that determines the overall market, usually the Standard & Poor’s 500 Index, or S&P 500. The S&P 500 is a market-capitalization-weighted index of 500 leading publicly traded companies in the United States.
To calculate beta, divide the variance (which is the measure of how the market moves relative to its mean) by the co-variance (which is the measure of a stock’s return relative to that of the market).
Here’s an example of beta:
- If a stock has a beta of 1%, it is highly correlated to the S&P 500.
- If a stock has a beta of zero, it is not very correlated to the S&P 500.
- If a stock has a beta of -1%, it is inversely correlated—in other words, it has a contrary relationship—to the S&P 500.
Beta gives investors additional insight when they do further analysis and ask, “Is there a reason why a particular stock is underperforming or outperforming?” Beta can help answer that question when evaluating relative performance overall because it might help shed light on the reason why the stock outperforms or underperforms during certain times.
A Sharpe ratio is helpful to determine whether the risk is worth the reward. It is used when comparing peers or ETFs that hold similar assets.
The calculation for the Sharpe ratio is the adjusted return divided by the level of risk, or its standard deviation.
According to Investopedia, “The Sharpe ratio’s numerator is the difference over time between realized, or expected, returns and a benchmark such as the risk-free rate of return or the performance of a particular investment category.”
Generally, when comparing similar portfolios, the higher the Sharpe ratio, the better because it shows an attractive risk-adjusted return, meaning the return after taking into account the degree of risk that was taken to achieve it.
Is it better to use the alpha, beta, or Sharpe ratio?
All three calculation methodologies will give investors different information. Alpha ratio is useful to determine excess returns on an investment. Beta ratio shows the correlation between the stock and the benchmark that determines the overall market, usually the Standard & Poor’s 500 Index. Sharpe ratio helps determine whether the investment risk is worth the reward.
How is risk-reward ratio calculated?
To calculate risk-reward ratio, take the expected return (reward) on the trade and divide by the amount of capital risked.
Do investments with higher risks yield better returns?
Not necessarily. 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. According to risk-return tradeoff, invested money can render higher profits only if the investor is willing to accept a higher possibility of losses.
The Bottom Line
Risk-return tradeoff is the trading principle that links risk with reward. According to risk-return tradeoff, if the investor is willing to accept a higher possibility of losses, then invested money can render higher profits. To calculate investment risk, investors use alpha, beta, and Sharpe ratios.