Investing Fundamentals

Understanding the Risk-Return tradeoff and how it can help you invest wisely

Rahul had been pleading with his father for over a month to revise his pocket money. Finally, his father decided to use this as an opportunity to teach him an important investing lesson. He called Rahul and told him that he was ready to reconsider his pocket money. He gave him 2 options to choose from:

  • Option A: I will increase your pocket money by 20% if you score above 90% in your upcoming exams. However, if you score below 90%, you pocket money will be reduced by 15%.
  • Option B: Your pocket money will be increased by 5% effective immediately and will not depend on how you score in your exams.

While it took some time for Rahul to figure out which option was suitable for him, he did learn an important investing lesson that day – there is always a risk-return tradeoff in investments. Higher the expected returns (note the word expected) form an investment option, the higher are the risks associated with it (more like Option A in this case). While investment options with lower risks will also have lower expected returns.

But what exactly is Risk?

Investments generally entail different types of risk driven by various factors (read What are the various types of risk associated with my investment). However, all of it boils down to one simple definition of risk – the chance that the actual return on your investment will vary from the expected return. For example, say you purchase mutual fund units worth Rs 10,000 today and plan to withdraw your money in 3 years. Historically, mutual fund units have yielded 12% annual return and hence you expect your investment to grow to approx. Rs 14,050 in 3 years time. Your risk here is the chance that your units will be worth less than Rs 14,050 (downside risk) in 3 years from today or the chance that your units will be worth more (Yes! Even this is called a risk – upside risk).

To put this in perspective, lets consider two investment options – shares of a Company (lets call this option A) & a bank fixed deposit (lets call this option B).

 Option AOption B
Type of investmentSharesBank FD
Expected return (%)15%7%
Return range with 95% chance9% - 21%6% - 8%

As you can see, while A has higher expected return, there is also a higher degree of uncertainty over actual returns (your actual returns could vary between 9% and 21% with a 95% chance). In B, you are more or less assured of earning close to the expected return (7%).

Food for thought: What do you think is the risk associated with buying a lottery ticket of Rs 100? Its actually very low. Surprised! Well, in a lottery, since chances of winning are extremely low, you are almost “certain” to lose Rs 100. Since degree of uncertainty over final outcome is so low, the risk in this context is almost nil.

To come back to our original point, investment A is a riskier investment option and hence offers a relatively higher expected return (to compensate for the associated risk) while investment B is a less risky investment option and hence offers a relatively lower expected return. The same is true for all kinds of investments.

This understanding of risk-return tradeoff is very important in making correct investment decisions. It helps you pick the right investment option bearing in mind how much risk are you willing to take. It also helps weed out fraudulent investment proposals. If someone comes to you and says that he has a proposal that will earn you a guaranteed 20% return (no risks), you should simply walk off! Nothing in life comes for free!

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Shubham Satyarth

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