It is natural for anyone to want more returns. However, would you still want it if more returns come with more risks? This is what the risk-return trade-off says — more potential returns mean more risks. This principle says people would always think that the lesser uncertainty, the lesser the potential returns. Hence, high uncertainty connotes high potential returns. The risk-return trade-off tells us that if an investor is willing to accept higher chances of losses, his invested money also can generate more profits.
What is the risk-return trade-off?
The risk-return trade-off is a principle that incorporates high risks with high rewards. But before anything else, there are many factors that we still need to consider. For instance, we have risk tolerance, years left before retirement, the possibilities of replacing the lost funds, and more.
If there is one significant thing that we mentioned from the bunch, it is time. Time plays an important role when we create a portfolio with a reasonable risk and reward level. Let us say that you are an investor willing to have equity investments for the long term. It means that you have what it takes to recover from the bear market risks and participate in bull markets simultaneously. But you can also be an investor who can only invest short term. Both of these equities have more risk propositions.
The risk-return trade-off and trading decisions
Many investors are aware of the risk-return trade-off principle. Hence, they maximize its use when they make trading and investment decisions. In fact, even those who do not know that there is a principle like this always consider the risks that come with the possibilities of more returns. Investors also use this when they assess their portfolios. And when we say portfolio assessment, we cannot take apart the holdings diversity assessments. Does the mix have too many risks? Does it have less than the preferred potential for returns? It will provide answers to these questions.
Let us gauge individual risks.
Let us say that you are looking at investments that may give high rewards and come with high risks. You can always incorporate the risk-return trade-off to the vehicle on an individual basis. It can also be applied on a portfolio as a whole. Options. Penny stocks. Leveraged ETFs. These are all examples of high-risk-high return investments. Portfolio diversification can reduce the risks that individual investment positions have. Furthermore, we say that options are risky investments on a single basis. However, if it does not have any similar investment on your portfolio, then the risks that the options will incur are only minimal.
Finally, let us hop on the portfolio level.
We mentioned that we could also encounter a risk-return trade-off on portfolios. Let us say that your portfolio contains all equities that have higher risk and potential returns. Inside this portfolio that only includes equities, you can increase the risk and reward if you focus on investments in particular sectors. Or else, you can also take individual positions that stand for a massive holding percentage. If you assess the accumulated risk-return trade-off of every position, you will know if your portfolio can assume sufficient risk. Is the risk enough to attain a long-term return target, or are the risks too much with the mix of holdings?