The Link Between Risk and Return
We would all like to have investments with high return and low risk. Despite the sales pitches for get-rich-quick schemes, such investments don’t exist. In his book, The Intelligent Portfolio, Christopher L. Jones explains the forces that cause higher-return investments to have higher risk.
Given a choice between two investments with the same expected return, investors would select the one with lower risk. Investors “expect higher returns as compensation for taking on the additional risk.”
Suppose for a moment that a high-return, low-risk investment existed. Investors would immediately start buying this investment and drive its price up to the point where the returns are lower and more consistent with the risk level. Market forces will always act to maintain the relationship between risk and return.
One thing I would add that Jones did not mention is that this relationship is based on our collective guess of the risks and returns of each type of investment. Such market wisdom is sometimes very wrong. Examples of this include tulip mania in the 17th century and all the speculative bubbles since then.
I tend to be sceptical of anyone who claims to have better insight into investments than the “market wisdom,” but markets do get prices spectacularly wrong sometimes. Unfortunately, this only becomes obvious to most of us after the bubble bursts.
Given a choice between two investments with the same expected return, investors would select the one with lower risk. Investors “expect higher returns as compensation for taking on the additional risk.”
Suppose for a moment that a high-return, low-risk investment existed. Investors would immediately start buying this investment and drive its price up to the point where the returns are lower and more consistent with the risk level. Market forces will always act to maintain the relationship between risk and return.
One thing I would add that Jones did not mention is that this relationship is based on our collective guess of the risks and returns of each type of investment. Such market wisdom is sometimes very wrong. Examples of this include tulip mania in the 17th century and all the speculative bubbles since then.
I tend to be sceptical of anyone who claims to have better insight into investments than the “market wisdom,” but markets do get prices spectacularly wrong sometimes. Unfortunately, this only becomes obvious to most of us after the bubble bursts.
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