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The Tradeoff Between Expected Return and Risk.

The Tradeoff Between Expected Return and Risk.

by Md. Atiqur Rahman Sumon -
Number of replies: 2

1. Investors manage risk at a cost - Lower expected returns (ER): Higher risk of investment gives the higher possibility of high return. But usually, Investors are not favorable to risk. they always try to avoid risk by investing in lower-risk projects or risk-free projects. 

2. Any level of expected return and risk can be attained - If the investors take risk they can get a high return on it. the scenario is constant on the vice vasa scenario. This means the amount of risk taken by an investor determines the expected return and actual return on that investment.

In reply to Md. Atiqur Rahman Sumon

Re: The Tradeoff Between Expected Return and Risk.

by esmot ara -

The risk-return tradeoff is the trading principle that links high risk with high reward. The appropriate risk-return tradeoff depends on a variety of factors including an investor’s risk tolerance, the investor’s years to retirement and the potential to replace lost funds. Time also plays an essential role in determining a portfolio with the appropriate levels of risk and reward. For example, if an investor has the ability to invest in equities over the long term that provides the investor with the potential to recover from the risks of bear markets and participate in bull markets, while if an investor can only invest in a short time frame, the same equities have a higher risk proposition.Investors use the risk-return tradeoff as one of the essential components of each investment decision, as well as to assess their portfolios as a whole. At the portfolio level, the risk-return tradeoff can include assessments of the concentration or the diversity of holdings and whether the mix presents too much risk or a lower-than-desired potential for returns.

Measuring Singular Risk in Context:

When an investor considers high-risk-high-return investments, the investor can apply the risk-return tradeoff to the vehicle on a singular basis as well as within the context of the portfolio as a whole. Examples of high-risk-high return investments include options, penny stocks and leveraged exchange-traded funds (ETFs). Generally speaking, a diversified portfolio reduces the risks presented by individual investment positions. For example a penny stock position may have a high risk on a singular basis, but if it is the only position of its kind in a larger portfolio, the risk incurred by holding the stock is minimal.

Risk Return Tradeoff at the Portfolio Level:

That said, the risk-return tradeoff also exists at the portfolio level. For example, a portfolio composed of all equities presents both higher risk and higher potential returns. Within an all-equity portfolio, risk and reward can be increased by concentrating investments in specific sectors or by taking on single positions that represent a large percentage of holdings. For investors, assessing the cumulative risk-return tradeoff of all positions can provide insight on whether a portfolio assumes enough risk to achieve long-term return objectives or if the risk levels are too high with the existing mix of holdings.