Assistant Professor
Higher risk is associated with higher probability of return and lower risk implies a lesser probability of return. This trade-off which an investor faces between risk and return while considering an investment proposal is known as risk-return trade off.
The risk – return trade off is very important in making correct investment decisions.Investment generally entails different types of risk. Risk in any investment includes systematic and unsystematic risk. Before selecting any security it is very important to understand the risk – return profile of the investment and the risk that it incorporates.
Systematic risk refers to the risk inherent to the entire market segment. It is also known as undiversifiable risk or market risk. It includes interest rate risk, inflation risk, market risk. Shifts in these areas affect the entire market. This risk can not be mitigated with diversification. On the other hand, unsystematic risk refers to the probability of loss within a specific industry or a security. It includes business risk, financial risk. Unsystematic risk is avoidable risk and can be decreased by using the techniques of diversification. Diversification simply means, “don’t put all your eggs in one basket.”
It is very important to understand the the basic nature of any security while investing because both risk and return are dependent on each other. If an investor wants to earn a higher return then he also has to take a higher risk and if an investor can’t bear the risk then he has to compromise with a lower return. With this, we can also say that in a market there are two types of investors one being the risk takers and the others are the risk aversers. Risk takers are happy in taking higher risk and risk aversers always try to keep their investment at low risk. For example: Mr. Malhotra faces a risk-return trade off while making his decision to invest. Option A includes depositing all his money into a Bank and earn a risk-free rate of return while keeping his investment safe while Option B involves investing in equities resulting in earning a greater rate of return but keeping principal amount at risk.
As shown in the diagram, risk and return moves in same direction. Rsk in any security is measured by standard deviation. Now let us understand the risk – return trade off in various asset classes
| Type of Asset | Risk Factor | Inherent risk |
| Cash and cash equivalents | low | Inflation risk |
| Short term bonds, government securities | low | Reinvestment risk, credit risk, inflation risk |
| Corporate bonds, debt funds, fixed income assets, PPF, FD, Post office savings | Medium risk | Reinvestment risk, credit risk, liquidity risk, tax risk |
| Gold, real estate, balanced funds, NPS | Medium to high | Liquidity risk, tax risk |
| Index funds | Medium to high | Market risk |
| Equity: Diversified equity, large cap, mid cap, small cap, micro cap, sectoral | High | Market risk |
| Derivatives | Very high | Market risk |
| Alternate investment | Very high | Liquidity risk, market risk |
| Private equity, venture capital | Very high | Liquidity risk, market risk |
Therefore, one needs to find out the right mix of risk and return which is quite an important task because the return needs to be in line with the long-term financial goal.
Ms. Deeksha Suneja
Assistant Professor
