Risk and Return Tradeoff

Risk and Return Tradeoff

Fin 402: Investment Fundamentals and Portfolio Management

Every investor has to face risk when investing, no matter which type of asset serves as the vehicle. Whether real estate, equity stock, corporate debt, mutual funds, or government securities, all investment types carry with them some level of risk. Investors and their portfolio managers must weigh the risk-return tradeoff to find investment choices that match an investor’s needs, goals, and risk tolerance.

In every investment there is a risk-return tradeoff. The returns expected reflect, in part, the risk associated with the venture; the additional return directly tied to the risk level is called the risk premium. The risk premium is the distinction between gambling and speculation. Investors willing to accept additional risk because the investor anticipates a favorable risk-return tradeoff are speculating. Gambling, on the other hand is the assumption or risk for no other reason than the pure enjoyment of taking risk. The difference is gamblers assume risk even though there is no risk premium (Bodie, Kane, & Marcus, 2008). The responsibility of a portfolio manager is to recognize the difference between speculations and gambling and help clients make reasoned choices.

The relationship between investment strategy and investment performance is direct, but often complex to determine the effects of the former on the latter. The use of an active investment strategy seeks to achieve returns that outpace the risk being borne. A more passive strategy, in addition to being low cost, is a way of developing a well-diversified portfolio that often mirrors the performance of the broader stock market (Bodie, Kane, & Marcus, 2008).

One measure of portfolio manager performance is to use the Sharpe Ratio. This ratio is one means to measure risk-adjusted performance. It seeks to evaluate the efficiency of the risks a portfolio experiences against the rewards which are...