Risk vs. Return

Lecture 3 discusses international stock exchanges & stock market efficiency and whether risk and return is correlated.

One of the most essential theories in finance is that risk and return are interconnected. Is it true? The more you risk, the more return you get back?

The principle behind risk vs. return is that potential return rises with an increase in risk. Low levels of uncertainty (low risk) are associated with low potential returns, whereas high levels of uncertainty (high risk) are associated with high potential returns. According to the risk-return trade off, invested money can render higher profits only if it is subject to the possibility of being lost.

Risk measures the probability of financial loss. Investors often compare risk, as measured by standard deviation of returns, to historical or expected return when making investment decisions. Typically, investors demand higher returns for investments they consider more risky. (Svetlozar & Rachev, 2011)

Investors believe the higher the risk of loss, the great the potential return. Contrariwise, the lower the risk of loss, the lower the potential return.

Conversely, Paris E. M. Murray, an American-born stockbroker in the Philippines argues that academics would have us believe that if we seek to generate high returns, we must expose ourselves to high risk. In other words, invested money can render higher profits only if it is subject to the possibility of being lost. Hence the refrain: “The higher the risk, the higher the return.” - This belief is false (E.M Murray, Invest Philippines, 2011)

Murray also debates that it is not the level of risk that determines the amount of return but it is actually controlled risk that keeps the risk of loss low and will generate higher returns. This is backed up by Seth Klarman’s assertion, “the less risk, the more return. They’re two sides of the exact same coin”.

“Academics say; the riskier it is the more return. But we say the less risky it is, the more return. So we’re really talking at complete odds with each other.” (Klarman, 2011)

From yet another point of view, a Wall Street trader, Nassim Taleb, made a statement that a lot of people take risks because they don’t know the odds. He suggests that they do not know what the true risk actually is which is why they take the risk in the first place. (Taleb, 2003)

Risk refers to the chance that some unfavourable event will occur.  Investment risk is related to the probability of actually earning less than the expected return; thus, the greater the chance of low or negative returns, the riskier the investment. (Ehrhardt, 2001)

A simple example of risk return trade-off is if you put your money into government bonds it is almost guaranteed that you will get your money back, unless the government goes bankrupt or is taken over, which is not very likely. So they do not pay a great deal of interest. On the other hand, the stock market is more risky, companies can go bankrupt more easily. Bad news can drop the price or good news can raise it drastically, so there is the potential to make a lot more money, but with a higher rate of risk. There is also the potential to lose a lot more money.