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.

  1. Accepting Risk

    Accepting risk occurs when a business acknowledges that the potential ...
  2. Country Risk

    A collection of risks associated with investing in a foreign ...
  3. Risk Assessment

    The process of determining the likelihood that a specified negative ...
  4. Modern Portfolio Theory - MPT

    A theory on how risk-averse investors can construct portfolios ...
  5. Market Risk

    Market risk is the possibility of an investor experiencing losses ...
  6. Country Fund

    An international mutual fund with a portfolio that consists entirely ...
Related Articles
  1. Investing

    Measuring a Fund's Risk and Return

    Learn the importance of the risk-return relationship in selecting a mutual fund.
  2. Managing Wealth

    Achieve Optimal Asset Allocation

    Minimize risk while maximizing return with the right mix of securities and achieve your optimal asset allocation.
  3. Managing Wealth

    How Risky Is Your Portfolio?

    Find out how you could be subject to larger losses than you think.
  4. Investing

    How to Construct a High-Risk Portfolio

    A high-risk portfolio requires finesse and knowledge, but it can produce above-average returns.
  5. Investing

    How To Manage Portfolio Risk

    Follow these tips to successfully manage portfolio risk.
  6. Investing

    Low Vs. High-Risk Investments For Beginners

    Understanding risk is key to better investing.
  7. Financial Advisor

    Risk Tolerance Only Tells Half The Story

    Just because you're willing to accept a risk, doesn't mean you always should.
  1. 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 >>
  2. 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 >>
  3. 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 >>
Hot Definitions
  1. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  2. Perfect Competition

    Pure or perfect competition is a theoretical market structure in which a number of criteria such as perfect information and ...
  3. Compound Interest

    Compound Interest is interest calculated on the initial principal and also on the accumulated interest of previous periods ...
  4. Income Statement

    A financial statement that measures a company's financial performance over a specific accounting period. Financial performance ...
  5. Leverage Ratio

    A leverage ratio is any one of several financial measurements that look at how much capital comes in the form of debt, or ...
  6. Annuity

    An annuity is a financial product that pays out a fixed stream of payments to an individual, primarily used as an income ...
Trading Center