What is the Risk-Return Tradeoff?

The risk-return trade-off states that the level of return to be earned from an investment should increase as the level of risk goes up. Conversely, this means that investors will be less likely to pay a high price for investments that have a low risk level, such as high-grade corporate or government bonds. Different investors will have different tolerances for the level of risk they are willing to accept, so that some will readily invest in low-return investments because there is a low risk of losing the investment. Others have a higher risk tolerance and so will buy riskier investments in pursuit of a higher return, despite the risk of losing their investments. Some investors develop a portfolio of low-risk, low-return investments and higher-risk, higher-return investments in hopes of achieving a more balanced risk-return trade-off.

A canny investor delves into the fundamentals of a prospective investment to gain insights into the actual amount of risk associated with it. If this investor perceives that the actual risk level differs from the general perception, then this difference can be exploited to achieve above-average returns.

Is the Risk-Return Tradeoff Valid?

Recent research indicates that the risk-return tradeoff concept is not entirely valid. The problem is that higher-risk investments do not necessarily generate a higher return. Instead, you are just investing money in a high-risk venture that is likely to yield a modest return or no return at all. The underlying issue is that high-risk ventures tend to be small, underfunded startup businesses that can easily fail. Conversely, a large and well-funded business may engage in the same venture and yet be at lower risk, since it has the funds to recover any losses sustained. Thus, you could invest in the larger business, which is lower risk, and still generate good returns.