The Trade-Off Between Risk and Return

The Trade-Off between Risk and Return
The Trade-Off between Risk and Return

Arguably, this is the most important issue in all the finance. The trade-off between risk in return is fundamental for financial frameworks and models including the capital asset pricing. And, there is a reason for that.

Using existing information to predict the future of an investment

When we pursue investment opportunities whether they are stocks, bonds, real estate or alternative investments we should have some idea of the returns we should expect to receive. Generally our expectations are and should be based on history.

Basically we assume that the existing information on how these kind of assets have performed and the returns they generated in the past will give us enough information to make valid decisions in a volatile present for an unknown future.

What 90 years of data tells us

Over time stocks significantly outperform bonds and both significantly outperform inflation. However, within each category of investment type, say stocks, the more risk that one takes the greater the return. These additional returns do not come without some cost as these different categories of securities present very different levels of risk.

Small stocks, those with market capitalizations in the bottom quartile stocks, have earned on average 16.9% each year since 1926. Compare this to the 12.1% return that larger companies have earned in the same way an  with the long-term corporate bonds which earned 6.3% on average each year outperforming the less risky long-term bonds issued by the Treasury whose root returns have averaged 5.9%.

The short-term is too volatile to help us draw clear conclusions

You might wonder why we look back over such a long period of time to measure performance and historical rates of return. Well, the reality is that the short-term can be volatile and as they say so often in commercials your actual results may vary. For example, in the 20 years between 1990 and 2010, we had two or three periods were stock prices increased significantly and rapidly and two periods were they declined just as precipitously.

However as we look at results over longer periods of time these short-term blips should be and almost always are evened out. We statistically measure this volatility in asset prices by the standard deviation of historical returns. This measures how much a particular year’s return varies in relation to long-term averages. If we look at historical data for stocks and bonds, as mentioned before, small-cap stocks have earned an average of 16.9% per year since 1926 even though standard deviation was of more than 32%.

Finance assets and portfolio returns

Finance asset and portfolio returns are based on expectations and those expectations in turn tree based on long-term historical observations. More broadly expected returns are based on the probabilities of expected outcomes and investing all we have to help us predict the future is the past.

While higher expected returns are positively correlated with higher risk measured by the expected variability and volatility of returns, just because you assume greater risk and investment does not necessarily mean you will be compensated for in terms of higher expected return. It depends on your diversification strategy.

Diversifying risk makes return more predictible

It makes common sense that if you put all of your eggs in one basket you are assuming a tremendous amount of very specific risk, the risk of this one particular company does very well or very poorly. If you take any single company there are going to be long stretches of time when either significantly outperforms or significantly underperforms the market

Yes that goes even for Apple in General Electric. Indeed we should never forget that Apple at present the company with the largest stock market capitalization was once on the verge of bankruptcy before Steve Jobs returned the company and turned it around. This sort of company level risk has different labels and indicates that there is always risk that a particular company might falter or fail.

The risk premium for a diversified porfolio

We should, therefore, expect to be compensated for taking on that additional risk. Again, it may or may not happen, since there is still some material market risk in a diversified portfolio portfolio, but we should expect to earn some premium.

This is known as the equity risk premium, and academics have argued extensively to how much this equity risk premium is, but today most most of them and market experts agree that it is between 5 and 6%. That is, if you invest in a portfolio of diversified stocks you should expect to earn the risk-free rate, whatever that rate happens to be at the time, +5 or 6%.

The trade-off between risk and return

To conclude, any estimations on assets expected returns are based on histrorical returns, which provide some basis for predicting likely future results at least over extended periods of time. We should nevertheless understand that, while we may expect certain outcomes, results may vary certainly over shorter investment periods.

While we may expect to earn higher returns with the more risk that we take, investors cannot and should not expect to be compensated with additional return for that portion of risk that is stock specific and can easily be diversified away by adding additional stocks to a portfolio.

By successdotinc

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