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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.

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