Risk and Return: Risk does not create incremental return, only Price can

While most other investors are preoccupied with how much money they can make and not at all with how much they may lose, value investors focus on risk as well as return.




Most investors seem confused about risk.

Some insist that risk and return are ALWAYS positively correlated, the greater the risk, the greater the return.  This is in fact, a basic tenet of the capital-asset-pricing model taught in nearly all business schools, yet it is not always true.

Others mistakenly equate risk with volatility, emphasizing the "risk" of security price fluctuations while ignoring the risk of making overpriced, ill-conceived, or poorly managed investments.

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.

Risk and return must be assessed independently for every investment.

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 investor 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.  

The risk you can assume is determined by: your sleeping point, your age and the sources and dependability of your noninvestment income.

The theories of valuation worked out by economists and the performance recorded by the professionals lead to a single conclusion:  There is no sure and easy road to riches.

High returns can be achieved only through higher risk-taking ( and perhaps through acceptance of lesser degrees of liquidity).

The amount of risk you can tolerate is partly determined by your sleeping point.

You should understand the risks and rewards of stock and bond investing and be able to determine the kinds of return you should expect from different financial instruments.

But the risk you can assume is also significantly influenced by your age and by the sources and dependability of your noninvestment income.

You should have a clear notion of how to decide what portion of your capital should be placed in common stocks, bonds, real estate and short-term investments.

You should develop  a sound philosophy and specific stock market strategies that will enable you as  amateur investors to achieve results as good as or better than those of the most sophisticated professionals.



A fitness manual for random walkers
Burton Malkiel

Decline in Market Price of holdings is not true risk or loss.

It is our conviction that the bona fide investor does not lose money merely because the market price of his holdings declines.  

Hence, the fact the decline may occur does not mean that he is running a true risk or loss.

If a group of well-selected common stock investment shows a satisfactory overall return as measured through a fair number of years then this group of investment has proved to be safe.

During that period, its market value was bound to fluctuate and likely than not, would sell for a while under the buyer's cost.

If that fall makes the investment risky, it would then have to be called both risky and safe at the same time.

This confusion may be avoided if we apply the concept of risk solely to a loss in value which:

• either is realized through an actual sale 
• or is caused by significant deterioration in the company's position 
• or more frequently, perhaps is the result of paying an excessive price in relation to the intrinsic worth of the security.

Many common stocks involve risks of such deterioration but it is our thesis that a properly executed group of investment in common stocks does not carry any substantial risk of this sort.


Ref:   Intelligent Investor by Benjamin Graham



Additional notes:

It is conventional to speak of good bonds as less risky than good preferred and that the latter as less risky than good common stocks.

From this was derived the popular prejudice against common stocks because they are not safe but we believe that what is here involved is not a true risk in the useful sense of the term.

If an investor's list has been competently selected in the first instance, there should be no need for frequent or numerous changes to the portfolio.

"No risk, no reward." "Higher risk, higher returns."

Risk:  The probability and value of financial loss.

Specific risk:  Risk that is associated with an individual investment.

Old cliche in finance:  "no risk, no reward".

But there is absolutely no reason to think that accepting risk inherently generates financial returns.  

The reality is the opposite:  all other things being equal, higher risk causes you lower financial gain, since the costs you incur as a result of the elevated risk corrode the value of your assets.

All other things being equal between two distinct investment options, if one option has greater risk, then the organisation selling that investment must offer a higher rate of return in order to attract investors.

It is not that the higher risk causes higher returns - it is that investors demand higher returns in order to accept the higher risk.


Various models are used to understand the relationship between risk and returns:

1. CAPM
2. APT
3. Value at Risk
4. Expected Shortfall
5. Ratings by underwriting agencies

Risk and Time

Click here for an enlarged version: http://www.norstad.org/finance/risk-and-time.gif

A Better Bar Chart Showing Risk Over Time

This chart shows the growth of a $1000 investment in a random walk model of the S&P 500 stock market index over time horizons ranging from 1 to 40 years. It pretty much speaks for itself, I hope - that was the intention, anyway.

The chart clearly shows the dramatic increasing uncertainty of an S&P 500 stock investment as time horizon increases. 
-  For example, at 40 years, the chart gives only a 2 in 3 chance that the ending value will be somewhere between $14,000 and $166,000.
-  This is an enormous range of possible outcomes, and there's a significant 1 in 3 chance that the actual ending value will be below or above the range! You can't get much more uncertain than this.

As long as we're talking about risk, let's consider a really bad case. If instead of investing our $1000 in the S&P 500, we put it in a bank earning 6% interest, after 40 years we'd have $10,286.
-  This is 1.26 standard deviations below the median ending value of the S&P 500 investment.
-  The probability of ending up below this point is 10%. In other words, even over a very long 40 year time horizon, we still have about a 1 in 10 chance of ending up with less money than if we had put it in the bank!

Look at the median curve - the top of the purple rectangles, and follow it with your eye as time increases. You see the typical geometric growth you get with the magic of compounding.
-  Imagine the chart if all we drew was that curve, so we were illustrating only the median growth curve without showing the other possible outcomes and their ranges.
-  It would paint quite a different picture, wouldn't it? When you're doing financial planning, it's extremely important to look at both return and risk.

There's one problem with this chart. It involves a phenomenon called "reversion to mean." Some (but not all) academics and other experts believe that over long periods of time financial markets which have done better than usual in the past tend to do worse than usual in the future, and vice-versa. The effect of this phenomenon on the pure random walk model we've used to draw the chart is to decrease somewhat the standard deviations at longer time horizons. The net result is that the dramatic widening of the spread of possible outcomes shown in the chart is not as pronounced. -  The +1 standard deviation ending values (the tops of the bars) come down quite a bit, and the -1 standard deviation ending values come up a little bit. 

-  The phenomenon is not, however, anywhere near so pronounced as to actually make the +1 and -1 standard deviation curves get closer together over time. 

-  The basic conclusion that the uncertainty of the ending values increases with time does not change.

http://www.norstad.org/finance/risk-and-time.html

Risk is dependent on both the nature of investments and on their market price

The risk of an investment is described by both the probability and the potential amount of loss.

The risk of an investment - the probability of an adverse outcome - is partly inherent in its very nature.

• A dollar spent on biotechnology is a riskier investment than a dollar used to purchase utility equipment.  
• The former has both a greater probability of loss and a greater percentage of the investment at stake.

In the financial markets, however, the connection between a marketable security and the underlying business is not as clearcut.

• For investors in a marketable security the gain and loss associated with the various outcomes is not totally inherent in the underlying business; 
• it also depends on the price paid, which is established by the marketplace.

Greater risk does not guarantee greater return, risk erodes return by causing losses.

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.

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.

Market Risk and Return

U Michigan / Economics


Risk and Return
By Jack Wheeler
Corporate Finance for Healthcare Administrators Lecture 9 of 20

http://academicearth.org/lectures/risk-and-return-healtchare