Financial Concepts: The Risk/Return Tradeoff

The risk/return tradeoff could easily be called the "ability-to-sleep-at-night test."

While some people can handle the equivalent of financial skydiving without batting an eye, others are terrified to climb the financial ladder without a secure harness. Deciding what amount of risk you can take while remaining comfortable with your investments is very important.

In the investing world, the dictionary definition of risk is the chance that an investment's actual return will be different than expected. Technically, this is measured in statistics by standard deviation. Risk means you have the possibility of losing some, or even all, of your original investment.

Low levels of uncertainty (low risk) are associated with low potential returns. High levels of uncertainty (high risk) are associated with high potential returns. The risk/return tradeoff is the balance between the desire for the lowest possible risk and the highest possible return. This is demonstrated graphically in the chart below. A higher standard deviation means a higher risk and higher possible return.

A common misconception is that higher risk equals greater return. The risk/return tradeoff tells us that the higher risk gives us the possibility of higher returns. There are no guarantees. Just as risk means higher potential returns, it also means higher potential losses.

On the lower end of the scale, the risk-free rate of return is represented by the return on Government Securities because their chance of default is low.

Determining what risk level is most appropriate for you isn't an easy question to answer. Risk tolerance differs from person to person. Your decision will depend on your goals, income and personal situation, among other factors.