What is Risk Return Trade Off?

What is Risk Return Trade Off?

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Risk return trade off - Taxationwealth

Whether it may be the start of the investment process or the end, the sole purpose for which any investment should be made is for return. No compromise is tolerated in getting the highest rate of return possible unless it is for tax saving purposes.

But in order to get apt returns one needs to have the perfect balance between the amount of risk involved and return delivered on an investment option. For example bank deposits can give low risk assurance while buying equity can give better returns.

Based on the risk profile of the investor, the decision regarding allocation of less or more risky investment products is made. The average investor is not risk seeking unless compensated by a really high rate of return percentage and this tendency to otherwise avoid risk is known as Risk Aversion.

The extra return a asset has to provide in order to motivate a investor to invest is known as Risk Premium.

Combining Asset Classes

In order to do asset allocation and enjoy the advantage of having multiple eggs in your basket one needs to understand how exactly asset allocation works. 

Understand different scenarios with the below case study.

Mr. Y is a retired investor who is keen to earn a decent return on his money. He is thinking to invest his money in a bank deposit. He is unwilling to invest in equity markets since he is concerned about the risk involved but he is aware he can generate a higher corpus with equity. Now what is the most apt option for Mr. Y?

The key considerations for Mr. Y are income from his corpus and protection of the capital invested. Now if the investor chooses to stay with bank deposits he will enjoy more secure investment with lower returns and then he won’t even be able to beat inflation and on the other hand equity can provide higher returns or completely even erode the capital invested.

Mr. Y may consider investing a portion of his money in equity and a portion in debt, the combination of which provides him with a better return and a level of risk he is able to digest and deal with.

In the above illustration adding 20% equity to his portfolio enhances the average return from 8% to 8.80%. The risk of equity is evident as the return swings from +30% to -10%. But Mr. Y’s portfolio itself continues to make a positive return, since the proportion invested in equity is still small. The higher return in those years when equity market did well may make up for the ones it didn’t. This is how diversification works and adjusts the risk and return to level it to the investor requirements.

The actual proportion in each asset class determines the overall risk and return of the portfolio, a critical decision that a financial advisor provides to his investors.

A portfolio generally does not provide a higher return from the addition of an asset without a corresponding increase in risk. If Mr. Y needed a return higher than 8.8%, he will have to increase the portion invested in equity and bear a higher risk.

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