How Investors Use the Risk Return Trade Off in Competitive Capital Markets
Game of Risk and Return
In life it is generally true that greater rewards are achieved through greater risk-taking. The principle of risk-return trade-off suggests that there is a strong positive relationship between the potential rewards of a decision and the risk needed to realize those rewards. In fact, it can be said that with great risk comes the possibility of great reward and great loss. This is the essence of the risk-return trade-off in investing.
It is reasonable to assume that investors work toward making decisions that will yield a high return with low risk. Given the choice between two alternatives that carry the same rewards yet one of the alternatives is less risky, most investors will choose the less risky alternative. This is why investors understand that risk and return are two indelibly linked concepts when it comes to investing money in any security, asset, or property.
The principle of risk aversion suggests that people, in general, avoid risky choices when alternatives exist that allow for the same level of benefit or return. In the psychology literature, risk aversion is an often-cited construct that captures a significant amount of behavior variability. In financial markets, investors are constantly on the lookout for either the same risk for a larger return, or the same return for lower risk. Doing so ensures that enough return is realized for a given risk level or not an excessive amount of risk is borne given the expected return of an investment.
Most investors are risk averse, seeking to minimize risk and maximize return. This behavior collectively creates intense rivalry among investors to seek out the best alternatives for themselves because investors are all looking out for their own self-interest. However, how does an investor decide how much risk is too much? What is an acceptable amount of risk given an expected return on an investment?
Each investor has a unique combination of goals and knowledge. It is often true that younger investors should invest in riskier assets to realize larger returns and risk the possibility of lower returns because with youth comes plenty of time to correct a course of action before it is too late. Older investors should risk less and thereby gain less to avoid a bad outcome which cannot be corrected or offset by time. The point is that there is no optimal risk-return trade-off sought by investors.
With so many alternatives to choose from and so many levels of risk available, most investors evaluate their situation and take on a level of risk appropriately. Of course, some investors take on too much risk, realize too many bad outcomes and go bankrupt. Such is the game of risk and return.
This post is part of the series: Financial Transactions: Principles and Theory
In competitive capital markets, financial transactions have several attributes that every good investor knows. By understanding the topic of risk-return trade-off, diversification, capital market efficiency, and time value of money, the investor is better suited to complete.