Guess what is this? It is the Chinese symbol for risk. The first sign means danger but the second sign means opportunity. This by far is the best definition of risk.
Now what does the commonly used term risk-reward trade-off mean? It simply means that with higher risk there is probability of earning higher return. Mind it probability but not guarantee!!
For example: If I invest all my money in a Fixed deposit account, I will earn a low return i.e. the interest rate paid by the bank, but all the money and the interest will be guaranteed by the bank.
While, if I invest in equities, I am exposed to a risk of losing all my investment but also a chance to get a much higher return compared to a fixed deposit. Again, notice, a chance to earn but not a guarantee!
Hence, it is a big fallacy that taking more risk will lead to a higher return. The risk-return trade-off theory only means that with higher risk the expected return (average return) should be higher which does not mean at all that the actual return will be higher. As an investor we should always be aware of our risk appetite and choose asset classes accordingly.
Secondly, not all types of risk lead to higher expected return. According to financial theories only those types of risk that cannot be diversified lead to higher expected return. So, it is always worthwhile to maintain a well-diversified portfolio. Few points that one should keep in mind while investing:
- Spread your investment among various asset classes, eg: stocks, bonds and real estate.
- Spread the risk across industries, as this will minimize the effect of risk in specific industries.
- Spread risk in equities by investing both in large-cap as well as small cap stocks.
Also Read 10 Common Mistakes made by Traders