Risk vs Return Tradeoff

In the investing world, the dictionary definition of risk is the chance that an investment’s actual return will be different than expected. Technically, this is measured in statistics by standard deviation. Risk means you have the possibility of losing some, or even all, of our original investment.

Low levels of uncertainty (low risk) are associated with low potential returns. High levels of uncertainty (high risk) are associated with high potential returns. The risk/return tradeoff is the balance between the desire for the lowest possible risk and the highest possible return. This is demonstrated graphically in the chart below. A higher standard deviation means a higher risk and higher possible return.

A common misconception is that higher risk equals greater return. The risk/return tradeoff tells us that the higher risk gives us the possibility of higher returns. There are no guarantees. Just as risk means higher potential returns, it also means higher potential losses.

On the lower end of the scale, the risk-free rate of return is represented by the return on U.S. Government Securities because their chance of default is next to nothing. If the risk-free rate is currently 6%, this means, with virtually no risk, we can earn 6% per year on our money.

The common question arises: who wants to earn 6% when index funds average 12% per year over the long run? The answer to this is that even the entire market (represented by the index fund) carries risk. The return on index funds is not 12% every year, but rather -5% one year, 25% the next year, and so on. An investor still faces substantially greater risk and volatility to get an overall return that is higher than a predictable government security. We call this additional return the risk premium, which in this case is 6% (12% – 6%).

Determining what risk level is most appropriate for you isn’t an easy question to answer. Risk tolerance differs from person to person. Your decision will depend on your goals, income and personal situation, among other factors.

Reference: http://www.investopedia.com/university/concepts/concepts1.asp#axzz1giDcOnzS

Market Risk and Hedge Funds

Hedge funds, including fund of funds (“Hedge Funds”), are unregistered private investment partnerships, funds or pools that may invest and trade in many different markets, strategies and instruments (including securities, non-securities and derivatives) and are NOT subject to the same regulatory requirements as mutual funds, including mutual fund requirements to provide certain periodic and standardized pricing and valuation information to investors. There are substantial risks in investing in Hedge Funds. Persons interested in investing in Hedge Funds should carefully note the following:

􀀁Hedge Funds represent speculative investments and involve a high degree of risk. An investor could lose all or a substantial portion of his/her investment. Investors must have the financial ability, sophistication/experience and willingness to bear the risks of an investment in a Hedge Fund.
􀀁An investment in a Hedge Fund should be discretionary capital set aside strictly for speculative purposes.
􀀁An investment in a Hedge Fund is not suitable or desirable for all investors. Only qualified eligible investors may invest in Hedge Funds.
􀀁Hedge Fund offering documents are not reviewed or approved by federal or state regulators
􀀁Hedge Funds may be leveraged (including highly leveraged) and a Hedge Fund’s performance may be volatile
􀀁An investment in a Hedge Fund may be illiquid and there may be significant restrictions on transferring interests in a Hedge Fund. There is no secondary market for an investor’s investment in a Hedge Fund and none is expected to develop.
􀀁A Hedge Fund may have little or no operating history or performance and may use hypothetical or pro forma performance which may not reflect actual trading done by the manager or advisor and should be reviewed carefully. Investors should not place undue reliance on hypothetical or pro forma performance.

􀀁A Hedge Fund’s manager or advisor has total trading authority over the Hedge Fund.
􀀁A Hedge Fund may use a single advisor or employ a single strategy, which could mean a lack of diversification and higher risk.
􀀁A Hedge Fund (for example, a fund of funds) and its managers or advisors may rely on the trading expertise and experience of third-party managers or advisors, the identity of which may not be disclosed to investors
􀀁A Hedge Fund may involve a complex tax structure, which should be reviewed carefully.
􀀁A Hedge Fund may involve structures or strategies that may cause delays in important tax information being sent to investors.
􀀁A Hedge Fund may provide no transparency regarding its underlying investments (including sub-funds in a fund of funds structure) to investors. If this is the case, there will be no way for an investor to monitor the specific investments made by the Hedge Fund or, in a fund of funds structure, to know whether the sub-fund investments are consistent with the Hedge Fund’s investment strategy or risk levels.
􀀁A Hedge Fund may execute a substantial portion of trades on foreign exchanges or over-the-counter markets, which could mean higher risk.
􀀁A Hedge Fund’s fees and expenses-which may be substantial regardless of any positive return- will offset the Hedge Fund’s trading profits. In a fund of funds or similar structure, fees are generally charged at the fund as well as the sub-fund levels; therefore fees charged investors will be higher that those charged if the investor invested directly in the sub-fund(s).
􀀁Hedge Funds are not required to provide periodic pricing or valuation information to investors.
􀀁Hedge Funds and their managers/advisors may be subject to various conflicts of interest.

Reference:http://www.hedgefund-index.com/