The risk-return trade-off

The level of risk and return in an investment is an important criterion for selection of investment instruments. Generally speaking, the higher the risk, the higher would be the returns, and lower the risk, lower the returns. So, the risk and return in an investment are directly correlated, which dictates the choice of investments.

Among all investments avenues available to an investor, equities are considered to be the riskiest ones. The simple reason being the price of a stock can go up or down not just every hour or minute, but every couple of seconds during market hours. More importantly, the movement of stock prices are totally unpredictable, which makes investment in equities so much more risky. However, an investor who riskshis money by trading or investing in equities can also expect handsome returns if he happens to be on the right side of the price movement; however, if the investor gets caught on the wrong side, he can suffer a heavy loss. So, the risk-return trade-off in equities is as high as it can possibly get.

The risk-return trade-off for investments in debt instruments is moderate as the prices of debt instruments are relatively stable and the risk of loss of capital is also low if the debt instruments have high credit ratings. In the case of debt, the risks are of two types, namely, interest rate risk and risk of default. The upward or downward movement of interest rates impact the prices of bonds, which have inverse correlation with the movement of interest rates. So if the interest rates go up, the bond prices fall, and if the rates go down, the bond prices increase. The risk of default by the issuer of debt instrument is another risk faced by the debt investor. Normally, if the debt instrument is assigned a higher rating by credit rating agencies, the risk of default is minimal.

Lastly, the risk-return trade-off for government securities and money market instruments such as commercial paper is the lowest as the government securities have sovereign guarantee and money market instruments are short term and have high liquidity and are, therefore, considered very safe. These securities offer the lowest returns, but the risk is also the lowest.