One of the basic and most important concepts in equity markets is that of risk-return trade-off in stock market. You need to understand equities in terms of other asset classes as well as the risk-return trade-off within the category of equities. For example, equities must generate higher rates of return than debt because the risk is also higher. We will see the risk-return trade off example in detail. Within the equity segment, small cap equities entail more risk and from the perspective of foreign portfolio investors, the emerging market equities are the riskiest. This can be interpreted in two ways. Firstly, asset classes with a higher return potential generally entail higher risk. Secondly, if you want to earn higher returns then you need to take on higher risk. That is how to calculate risk-return trade off. Consider the chart below.
As the chart above clearly indicates, there is a positive relationship between risk and return. When you are invested in safe assets like bank FDs, government bonds or treasury bills, then your risk is the lowest but so are your returns. As you go up the risk ladder, your returns increase proportionately and so does your risk. Here risk is defined as the volatility or the standard deviation of the returns. That means the more volatility of returns that you are willing to put up with the greater is your risk appetite and, therefore, higher is your potential for returns.
Understanding risk-return trade-off with respect to mutual funds
In the Indian context, one of the best ways to understand the risk-return trade-off is through mutual funds. Mutual funds broadly offer you 3 distinct products viz. pure debt, pure equity and a hybrid of equity and debt. The chart below captures the risk-return of the various classes of mutual funds. In fact, if you look at the returns on these asset classes over a 5-year horizon, it will broadly correspond to this kind of a risk-return chart pattern.
At the shorter end of risk you have debt and at the longer end of risk you have equity funds. In between you have different categories of hybrids like MIPs, balanced funds, dynamic funds etc.
Why the risk-return trade-off is important to an investor?
There are 6 essential reasons why the risk-return trade-off has immense practical application. Let us look at these 6 unique applications of the risk-return trade-off.
It helps you to understand the risk-return relationship. This forms the basis of your portfolio creation and long term planning towards your financial goals. If you have a longer time frame you need to earn higher returns and therefore you can afford to take on higher risk. That means; you can reach your goals with a smaller SIP outlay each month.
It is very important to grasp the causality of the relationship. For example, higher returns entails higher risk but higher risk does not necessarily mean higher returns. For example, you can take a very high risk by putting all your money in a commodity fund. But if the commodity goes through a prolonged multi-year bear cycle then your portfolio will grossly underperform and give negative returns although you have taken on higher risk. Hence you should only take on calibrated and measured risk.
Creating a risk-return matrix lies at the core of financial planning. One of the best ways to do it is to bucket asset classes into various risk-return buckets and then select the asset class that corresponds closest to your financial goals. For example, liquid funds for 1 year goals, Short term funds for 2 year goals, debt funds for 3 years goals, debt funds for 5 year goals, balanced funds for 7 year goals, Equity funds for goals above 10 years etc. This matrix simplifies your job of financial planning and asset allocation.
The risk-return trade-off helps you to quantify the units of risk you are willing to take for every unit of return. Let us understand this from the point of view of trading. Your risk-return acceptability is 3:1. That means if your stop loss is 1% lower than your profit target must be 3% higher. Extrapolate this concept to your financial investments and you have a quantifiable risk-return matrix in your hand.
It helps in portfolio optimization. What do we understand by portfolio optimization? For a given level of return you need to minimize the risk or for a given level of risk you need to maximize your returns. Once you have the total risk that you are willing to take, you can break it up into sub components for each asset class.
Remember, portfolio creation is not just about aggregating assets but also about understanding their internal correlations. Lower the correlation of assets in a portfolio, the lower is the risk due to internal risk set-offs. When you have laid out the risk-return matrix and know that risk needs to be reduced in tune with returns, you have a choice of diversification. That is the luxury that risk-return trade-off accords to you.