Risk-Return Trade Off: Meaning, Importance & Uses

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Risk return trade-off is one primary and most important concept while investing in mutual funds or the stock market. This investing term describes the relationship between the risk investors take and the potential to earn returns. The two move in tandem, i.e. as the risk increases, there is potential for higher returns. Likewise, the returns are likely to be lower for a less risky investment. As an investor, it is crucial to understand the meaning of risk return trade off and how to calculate it. Read our article to know more about risk return trade off.

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What is Risk Return Trade Off?

Every type of investment has some degree of risk associated with it. Also, the level of risk may vary depending on the type of investment. For instance, equities carry the highest level of risk than bonds in the financial market because they are sensitive to market volatility. Also, equities have the potential to generate the highest returns. Therefore, risk return trade off means that the potential of generating return increases with an increase in risk.

An appropriate risk return trade-off depends on factors like an investor’s risk tolerance level, investment duration and the potential to replace lost funds. Investment duration plays an important role in determining a portfolio’s appropriate levels of risk and return. For instance, if an investor invests in equities for the long term, it provides the ability to recover from the risks in bear markets and participate in bull markets. Similarly, investing in equities for the short term can involve a higher proportion of risk.

Risk return trade-offs are essential components of investment decisions and assessing the portfolio. Also, it helps analyse the portfolio holdings, their concentration and the appropriate mix to balance risk and return at a portfolio level.

Importance of Risk Return Trade Off in Mutual Funds

The following are essential reasons to understand the risk return trade off in mutual funds –

Understanding the relationship between risk return trade-off forms a base for portfolio creation. Also, time plays an essential factor. If you have a longer time horizon, you need higher returns and can afford to take higher risks. For instance, you can plan your financial goal with a small monthly SIP.
You must also understand the cause and effect of this relationship. For instance, higher risk does not necessarily mean higher returns. If you choose to put all your money in a sector fund. But if a sector undergoes a multi-year bear cycle, then your portfolio will underperform. Also, it will give negative returns even though you have taken a higher risk. Therefore, you should always measure the risk before investing.
Financial planning helps to create a balance between risk and return. The best way is to list the various asset classes and the risk associated with each asset class. Next, select the asset class according to your financial goals. For instance, if you have a short-term goal of a family vacation, you can select a debt fund. On the other hand, if you want to plan for children’s education in the long term, you can choose an equity fund.
Risk return trade off helps in portfolio optimisation. Portfolio optimisation means how to minimise risk for a given level of return or, for a given level of risk, how to maximise returns. As an investor, once you understand the total risk you are willing to take, you can break it into different asset classes.
Portfolio creation is not just about aggregating different mutual funds together. It is about creating diversification in the portfolio and managing the asset allocation and maintaining risk return matrix.

How is Risk Return Trade Off Calculated in Mutual Funds?

Mutual funds can help spread out risk as you invest money in a pool of investments. The pool has a mix of equities, bonds or other securities with different risk profiles. Hence, if one underperforms or becomes volatile, the other investments help to balance it. While investing in mutual funds, you can determine the risk with different metrics.

The following are some metrics that can be used to calculate risk return trade off in mutual funds –

Alpha

Alpha measures the risk-adjusted returns of a mutual fund scheme against its underlying benchmark. A scheme with zero alpha indicates that it has delivered the same returns as the benchmark. A scheme with negative alpha indicates that the fund has underperformed its benchmark. On the other hand, a scheme with positive alpha indicates better performance than its benchmark. Thus, the higher alpha, the higher the potential returns.

Alpha = (Mutual Fund Return – Risk Free Return (Rf)) – [(Benchmark Return – Risk Free Return (Rf)) * Beta]

In simple words, alpha helps to determine how much returns the mutual fund investment can potentially generate. Even though a higher alpha indicates higher returns. It is not the only metric to evaluate a fund’s performance.

Beta

Beta measures the volatility of a mutual fund towards dynamic market movements. In simple words, this metric measures the sensitivity of a mutual fund portfolio against the market. Beta helps to understand how the fund responds to market fluctuations. Also, the beta of the market or benchmark is always one. A fund with a beta lower than one suggests lesser volatility when compared to its benchmark index. On the other hand, a fund with a beta of more than one suggests higher volatility than its benchmark.

Beta = (Mutual Fund Return – Risk Free Rate (Rf)) / (Benchmark Return – Risk Free Rate (Rf))

You can decide whether to include a mutual fund in your portfolio based on the beta value. New investors or risk-averse investors should choose funds with a beta of less than one as they are less volatile. At the same time, risk-takers can pick funds with higher beta. However, higher beta does not guarantee high returns, as it does not give information about the fund’s inherent or absolute risk.

Recommended Read: Alpha and Beta in Mutual Funds

Sharpe Ratio

Sharpe ratio is a performance metric that helps in estimating the risk-adjusted returns potential of a mutual fund scheme. Risk-adjusted returns indicate the return that a mutual fund scheme generates over and above the risk-free rate of return. In simple words, the Sharpe ratio helps to determine the potential returns a scheme can generate against each unit of risk it undertakes.

The higher the ratio, the better the return potential compared to the risk. A higher Sharpe ratio indicates the return potential of a fund is higher than expected at a particular risk level. Similarly, if the Sharpe ratio is negative, it signifies that the returns potential of a fund is lower than the risk carried by the fund.

Share Ratio = (Mutual Fund Returns – Risk Free Rate) / Standard Deviation

Moreover, the Sharpe ratio considers the investment’s inherent risk(standard deviation). Thus, you can analyse the fund’s risk to understand if it can generate returns compared to the risk-free rate.

Standard Deviation

Standard deviation helps to measure how much a portfolio return deviates from its average. Simply put, a standard deviation of a mutual fund shows how much a mutual fund’s performance deviates from expected returns. A higher standard deviation shows higher volatility and carries a higher level of risk than a fund with a lower standard deviation. Therefore, standard deviation measures total risk rather than just market-related volatility.

You can use standard deviation as a performance ratio to compare two funds in the same category. You cannot determine whether the standard deviation is high or low without comparing it to other funds in the same category.

The above are the four metrics used to calculate the risk for different mutual funds while taking an investment decision. There is more emphasis on building a well-diversified portfolio to protect against market volatilities. Also, risk return trade off applies to every investment. Hence, you must focus on your investment objective, horizon, and risk tolerance level so that risk return trade-offs match your investment portfolio.

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