Monday, 13 February 2012

Risk and Return - Find Investments offering High Returns with Low Risk

A positive correlation between risk and return would hold consistently only in an efficient market.  Any disparities would be immediately corrected, this is what would make the market efficient.

In inefficient markets it is possible to find investments offering high returns with low risk.  These arise 
  • when information is not widely available, 
  • when an investment is particularly complicated to analyze, or 
  • when investors buy and sell for reasons unrelated to value.  
It is also common place to discover high-risk investments offering low returns.  Overpriced and therefore risky investments are often available
  • because the financial markets are biased toward overvaluation and 
  • because it is difficult for market forces to correct an overvalued condition if enough speculators persist in overpaying.  
  • Also, unscrupulous operators will always make overpriced investments available to anyone willing to buy, they are not legally required to sell at a fair price.
Since the financial markets are inefficient a good deal of the time, investors cannot simply select a level of risk and be confident that it will be reflected in the accompanying returns.  Risk and return must instead be assessed independently for every investment.  

In point of fact, greater risk does not guarantee greater return.  To the contrary, risk erodes return by causing losses.

It is only when investors shun high-risk investments, thereby depressing their prices, that an incremental return can be earned which more than fully compensates for the risk incurred.

By itself risk does not create incremental return; only price can accomplish that.

1 comment:

agricultural investments said...

I am a Brit living in the States and subscribe to that basic notion of "buy low-sell high". It seems remarkably simple, yet it is also true. There is no reason one cannot buy high quality securities with a low beta to global markets at reasonable prices. Indeed, many people do make the mistake of blindly connecting high risk with high return, but that is simply a fallacy.