Risk and return are linked
On average, you only get more return if you take on more risk for it. If someone promises you high returns without risk, they've either missed something or they're trying to fool you.
Learning objective: After this lesson you'll recognize a promise of high returns without risk as a warning sign.
Why would anyone pay you eight percent interest when they can get the same money elsewhere for three? Because something can go wrong at eight percent. The difference is the price of uncertainty.
Competition for returns
That follows from competition. If there were high returns without risk anywhere, everyone would take their money there until the return was back to normal. That happens all the time, and very fast.
Expected does not mean certain
Watch the word expected. More risk doesn't mean you get more. It means you could get more on average and could also lose everything in a single case.
Protection from fraud
For you this is good protection against fraud. If someone offers you twelve percent a year, guaranteed and risk free, you haven't found an opportunity. Most likely you're dealing with a fraudster. This one rule has saved more people's money than any analysis method.
Experts split the expected return into two parts: the interest you get without risk, for example on short term government bonds, and a risk premium on top. The best known model for this is called CAPM. Its most important point is easy to miss. You only get paid for risk you can't get rid of by spreading your money.
Single-company risk
If Jan buys shares in just one company, he also carries the risk that this particular company has bad luck, say because a product flops. The market pays him nothing extra for that, because he could avoid the risk through diversification. Ten individual stocks instead of a broad index therefore mean much more volatility with roughly the same expected return. That's risk nobody pays you for.
Limits of the relationship
The relationship holds on average and over long periods. In single years, and sometimes over decades, riskier investments have done worse than safe ones. In 2019 Japanese stocks were still below their 1989 peak. If that were impossible, there'd be no risk and so no premium either.
Summary
- The risk premium is the reward for carrying uncertainty.
- You only get paid for risk that can't be diversified away.
- There's no high return without risk. This rule protects you from almost every scam.
Did you get it?
Why isn't the risk of a single stock paid for separately?
Because it can be avoided by spreading your money. The market pays nothing for avoidable risk.
Does more risk automatically mean more profit?
No. It means a higher expectation, but also a wider range of possible outcomes, including very bad ones.
What follows for offers with high, safe returns?
That something is wrong. That combination doesn't last long under competition.
Check your understanding
Your task
Someone advertises a guaranteed return of 1.5 percent per month. Work out how many percent that is over a year by multiplying 1.015 by itself twelve times. Compare the result with what your savings account pays and write down three questions you would ask the provider.
Sources and further reading
- William Sharpe's 1964 paper in The Journal of Finance formally derived the Capital Asset Pricing Model (CAPM), showing that only non-diversifiable market risk justifies a risk premium. View source ↗