02) Financial Concepts: The Risk/Return Tradeoff

by · October 6, 2010

The risk/return tradeoff is often called the “ability-to-sleep-at-night” test. Some people can afford to financially skydive without even blinking an eye, but most cannot do so without a security harness. It is important to know what level of risk you are comfortable assuming. Tolerance to risk differs from one person to another, and is influenced by factors such as income, goals and lifestyle.

In the world of investment, risk is defined as the chance that an investment’s actual return may be different than expected. Risk is the possibility of losing some, if not all, of the original investment.

Those investments with low potential returns are known as low risk (low levels of uncertainty) and conversely, high risk (high levels of uncertainty) are associated with high potential returns. The balance between achieving the lowest possible risk and the highest possible return is the risk/return tradeoff.

Risk is measured statistically through standard deviation. A higher standard deviation equates to a higher risk and higher possible return.

The risk/return tradeoff tells us that a higher risk offers the possibility of a higher return but is not always guarantee. A risk may be a means for higher potential returns and inversely, a higher potential loss.

Return on U.S. government securities is called a risk-free rate of return because their chance of default is next to nil. If, for instance, the risk-free rate is 6%, the entire 6% can be earned for the year. The question now would be: Who would want to earn only 6% when index funds average 12% per year? The answer to this is risk is carried by the entire market. The return on index funds is not 12% but -5% for a year, 25% the next, and so on. Greater risk and volatility is still faced by the investor to get an overall return that is higher than a predictable government security. This additional return is called risk premium. In this case, the risk premium is 6% (12% – 6%).