The Limits of Risk Premium

In a previous article we discussed how increasing a portfolio’s risk level can increase expected returns. This risk premium is most dramatic for long-term returns. You might ask can we keep increasing the risk level indefinitely to get ever higher expected returns?

The short answer is no. Starting from a low-risk portfolio of fixed-income investments, we can increase risk and return by adding a diversified mix of equities. However, once we get to the all-stock portfolio, the party is pretty much over.

Unless you have very unusual stock-picking skills, choosing individual stocks increases risk without increasing the expected return. There are many ways to increase risk, but most of them give lower returns, such as casino gambling and lottery tickets.

To get higher expected returns along with the higher risk requires leverage. This means borrowing money to invest. Unfortunately, the interest on borrowed money cuts into the expected returns.

Many analyses of leverage assume that we can borrow money at the same interest rate that we are paid on cash savings. This just isn’t true. The interest rates on my loans are higher than the interest rate I can get on my cash savings. And as I borrow more money, my financial state becomes more precarious, and lenders will demand even higher interest rates.

Even a small gap between the interest rate on debt and the interest rate on savings can prevent leverage from giving any added expected return. For the average person, it doesn’t make sense to seek higher risk than an all-stock low-cost diversified portfolio.

Comments

  1. AnonymousAugust 20, 2008 at 9:23 AM

    "...it doesn’t make sense to seek higher risk than an all-stock low-cost diversified portfolio.

    I'll go one step further. It makes sense to decrease risk even further. The individual investor can do that by adopting conservative option strategies.

    Investors who don't use options tend to think of them as tools for gamblers, but in reality, options can be used to reduce the risk of investing.

    http://blog.mdwoptions.com/options_for_rookies/

    ReplyDelete
  2. Michael JamesAugust 20, 2008 at 9:49 AM

    Mark: Option strategies for reducing risk that I've looked at also reduce the expected return.

    ReplyDelete
  3. AnonymousAugust 20, 2008 at 10:17 PM

    It is best to seek higher returns and lower risk (level of risk defined by your knowledge of the investment and not by the perceived risk).

    ReplyDelete

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