Day 5: Risk/Return Trade-Off - “No Risk, No Reward”


  

 

It is all about Min(Risk)/Max(Return)

Higher risk is associated with greater probability of higher return and lower risk with a greater probability of smaller return, as illustrated in Figure 6. Generally, the Risk/Return trade-off is calculated with the the aforementioned key drivers of returns in combination with Risk FMR  such as STDEV, Alpha/Beta, the Treynor/Sharpe ratio,  VaR/CVaR, R-squared, DCR,  DER, ICR, and DCL. Let’s say we have to select either TSLA or AAPL based upon current EPS and STDEV values (Q4 2021):

Table 14: Example EPS and STDEV for TSLA and AAPL.

Stock

EPS $ Q3 2021

STDEV Q4 2021

TSLA

1.86

3.56

AAPL

1.3

1.54

 

Even though EPS(TSLA)>EPS(AAPL), your investment in TSLA would be considered  much more risky than that in AAPL because STDEV(TSLA)/STDEV(AAPL)~2.3. 

For instance, in the case of mutual funds, investors determine the trade-off with the help of Alpha, Beta, Sharpe Ratio, and STDEV metrics. A positive Alpha indicates that the fund outperformed its benchmark. Funds with lower Betas are highly recommended to new investors as they are less volatile. But higher Beta does not guarantee higher returns. If the Sharpe ratio is below 1, it signifies that the returns potential of the fund is lower than the quantum of risk carried by the fund. A higher STDEV of a mutual fund scheme means that the fund is volatile and carries a higher level of risk as compared to a fund with a lower STDEV.

As you can see from the table below, different asset classes offer varying levels of potential return and market/inflation risk.

Table 15: Risks and returns of major asses classes.

Major Asset Class

Market Risks

Inflation Risks

Long-Term Returns

Stocks

High

Low

High

Bonds

Low

High

Low

Money market instruments

Low

High

Moderate

 

For example, unlike stocks and corporate bonds, government T-bills offer guaranteed interest — although money market funds that invest in them do not.

 

 

Comments

  1. VA DigHiSciFebruary 6, 2022 at 3:24 AM

    The risk-return trade-off is the crux of the matter as the potential return rises with an increase in risk. In fact, invested money can render higher profits only if the investor will accept a higher possibility of losses. Based upon the outcome of Days 1-4, the objective is to accept only the largest expected return at a well-justified level of risk.

    ReplyDelete
  2. VA DigHiSciFebruary 6, 2022 at 3:24 AM

    The Bottom Line: Before you decide how you'll divide the asset classes in your portfolio, make sure you know the possible risks and rewards of each asset class. As with any security, past performance doesn't necessarily indicate future results. And asset allocation does not guarantee a profit.

    ReplyDelete

Post a Comment

Popular posts from this blog

Heads-Up: Upswing Resilient Investor Guide - Min(Risk) Control

Image
  Credit ratings  of companies and countries are most popular universal tools for helping investors to gain insight into different investment environments and to understand the risks and advantages these environments pose [1]. Globally, there are three main ratings agencies that provide credit ratings: Moody’s, S&P, and Fitch. Figure 1 gives an idea of the different rating symbols that Moody's and Standard & Poor's issue [1]. These ratings are considered to be investment grades consistent with the TLS Red “Junk”, Amber BBB and Green (A, AA and AAA) scores. For completeness, it is worth mentioning the monthly Zacks Stock Rank [18] that will help you find the best mutual funds to outperform the market. The Zacks Industry Rank is the average Zacks Rank  for all companies within a specific industry group. Most risk ratings determine the enterprise risk which consists of the business risk (volatility of cash flows) and the financial risk of the capital structure. A firm with
Read more

Max(Reward) Control

Image
   At the end of the day, we are interested in measuring the probability of gaining max(Reward) from an investment. In doing so, we calculate Return on Investment (ROI) as follows [1,3]: ROI=[(Net Return)/Cost]*100%= (Capital Gains)-Commission+(Dividend Yield) and Annualized ROI = [(1+ROI)**(1/n)-1]*100%, where n is the number of investment years.   It is clear that the negative values ROI<0 mean that total costs are greater than returns (red score), whereas positive values ROI>0 indicate that net returns are positive because total returns are greater than any associated costs (green/amber). Even though ROI is a direct measure of profitability, it does not adjust for risk. Both ROI and Return On Equity (ROE) are popular measures of financial performance and profitability [1]. While ROI is total profit divided by your initial investment ,  ROE, on the other hand, measures how much profit a company generates when compared to its shareholders' equity.   Because shareholders'
Read more

Appendix B: More Real World Examples

Image
  Risk/Reward Ratio Let’s consider the following example to understand RRR. Investor A wants to create a balanced portfolio using the following input data: Asset Value 10000 Accepted Risk 0.1 Time Period Y 1 Predict Growth 0.2   This is about investing $10000. He is willing to accept 10% of the risk with the expected 20% of the return on a short-term investment of 1Y. He shortlisted the two stocks, AAPL and MSFT, at the current prices $157 (AAPL) and $330 (MSFT) per share. He analyzed both stock trends using historical market data. According to his stock BI analysis, the predicted AAPL share price range is $100-200, whereas the predicted MSFT share price range is $300-400 in a period of 12 months: Stock Current Price Stop Loss Target AAPL 157 100 200 MSFT 330 300 400
Read more