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What is Risk-Return Trade-off?
It is the nature of financial functions that higher-risk investments offer more returns. Similarly, low-risk investments return less. For example, if you invest in shares, the risk is more there. However, the returns will be higher too in equities in comparison to a less risky investment such as government bonds. This relation between risk and return is popularly called the risk-return trade-off in finance.
In the case of mutual funds, the funds are named according to the market cap of company equities, such as small-cap, mid-cap, and large cap funds. Here, if the fund deals with only small-cap, the funds' investments will be made only in equities of small-cap companies. This is applicable to all other types of mutual funds investments. It is known to all that the higher risk the mutual funds investments go through, the more will be the returns.
Note − Risk return trade-off is applicable to all finance activities. Higher risk entails more returns while lower risks offer fewer returns. This can be understood well by following the working principles of mutual funds.
The simple formula between risk and return is given by
Return = Risk Free rate + Risk Premium
Note − The two factors necessary to calculate return are the risk-free rate and the risk premium.
The Risk-Free Rate
The risk-free rate is the rate offered by default-less government security.
An investor seeking higher returns will naturally be interested in risk premium as the risk-free rate is a constant for a given financial function. Higher the risk of action, the premium will be greater leading to more returns. Therefore, a proper balance between return and risk should be maintained to maximize the value of a share in the market. This is a risk return trade-off and every company has to go through this trade-off in the market.
The Risk-Adjusted Rate
However, to calculate the risk-adjust discount rate, a risk-free rate must be combined with a risk-free premium. The financial managers usually try to adjust the risks against the returns. Taking too much risk is avoided and the managers follow the formula given above to adjust the risk against the premiums. This is known as the risk-adjusted rate.
Note − Both risk-free rates and risk-adjusted rates are important to calculate the risk of an investment. Risk-free rates are obtained from default-less government securities.
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