Question

 

Discuss the concept of the risk-return trade-off and how it may apply in different circumstances.

Answer 1

An investor must decide the level of risk appropriate for him. Risk tolerance is different for different persons and depends on individual’s current circumstances- age, income & future goals. Depending upon the tolerance, one might be willing to take significant investment risk, or one might prefer to invest safely. Risk and return are concepts which occur in opposite direction. Risk is defined as chance of actual return being less than the expected return. Return is defined as gains of the investment. On safe side of spectrum, risk-free return is represented by return on U.S. Government Securities, because their chance of default is close to zero. Hence, if suppose risk-free rate is 7%, this would mean that investors can earn 7% per year on their investments, essentially without risking anything.We have seen that at low risk level, returns also tend to be low and high risk investments give high returns and hence the risk-return trade-off means that higher risk is associated with possibility of higher returns but with nothing guaranteed, it doesn't mean that higher risk doesn't necessary imply higher return. Also, higher risk means higher potential losses on investment. The trade-off is balance between lowest possible risk & highest possible return.