Investing in equity markets is a risk-return trade-off. You need to take on higher risk to earn higher returns but higher risks by themselves do not assure of higher returns. Risks have to be calibrated and monitored and that is a trade off. When you invest in mutual funds, you may not get the concentrated returns of direct equities, but you get the added benefit of professional management and diversification. That is your trade off. You need to understand equities in terms of other asset classes as well as the risk-return trade-off within equities. For instance, equities must generate higher rates of return than debt because the risk is also higher. Within equities, small cap stocks entail greater risk and from the point of view of FPIs, emerging market equities are the riskiest.

What are the implications of the risk return trade off in equities? There are actually two implications. Firstly, asset classes with a higher return potential generally entail higher risk. Secondly, if you want to earn higher returns then you need to take on higher risk. The caveat is that higher risk does not guarantee higher returns because risk has to be calibrated. What we can glean from this argument is that there is a positive correlation between risk and return. When you invest in safe assets like bank FDs, government bonds or treasury bills, your risk is the lowest but so are your returns. As you go up the risk ladder, returns increase proportionately but then so does risk. Let us come back to the definition of risk here. Risk is defined as the volatility or the standard deviation of the returns. If you have been wondering all these years as to why the VIX chart of the Nifty and the Nifty value chart move negatively, this is the reason. It reflects how risk tends to depress equity returns in the short run but actually facilitates up to a point in the long run.