The Risk Return Trade Off

Investors invest for anticipated future returns, but those returns rarely can be predicted precisely. There will almost always be risk associated with investments. Actual or realized returns will almost always deviate from the expected return anticipated at the start of the investment period. For example, in 1931 (the worst calendar year for the market since 1926), the stock market lost 43% of its value. In 1933 (the best year), the stock market gained 54%. You can be sure that investors did not anticipate such extreme performance at the start of either of these years.

Naturally, if all else could be held equal, investors would prefer investments with the highest expected return.2 However, the no-free-lunch rule tells us that all else cannot be held equal. If you want higher expected returns, you will have to pay a price in terms of accepting higher investment risk. If higher expected return can be achieved without bearing extra risk, there will be

2The "expected" return is not the return investors believe they necessarily will earn, or even their most likely return. It is instead the result of averaging across all possible outcomes, recognizing that some outcomes are more likely than others. It is the average rate of return across possible economic scenarios.

Part ONE Elements of Investments risk-return trade-off

Assets with higher expected returns have greater risk.

a rush to buy the high-return assets, with the result that their prices will be driven up. Individuals considering investing in the asset at the now-higher price will find the investment less attractive: If you buy at a higher price, your expected rate of return (that is, profit per dollar invested) is lower. The asset will be considered attractive and its price will continue to rise until its expected return is no more than commensurate with risk. At this point, investors can anticipate a "fair" return relative to the asset's risk, but no more. Similarly, if returns are independent of risk, there will be a rush to sell high-risk assets. Their prices will fall (and their expected future rates of return will rise) until they eventually become attractive enough to be included again in investor portfolios. We conclude that there should be a risk-return trade-off in the securities markets, with higher-risk assets priced to offer higher expected returns than lower-risk assets.

Of course, this discussion leaves several important questions unanswered. How should one measure the risk of an asset? What should be the quantitative trade-off between risk (properly measured) and expected return? One would think that risk would have something to do with the volatility of an asset's returns, but this guess turns out to be only partly correct. When we mix assets into diversified portfolios, we need to consider the interplay among assets and the effect of diversification on the risk of the entire portfolio. Diversification means that many assets are held in the portfolio so that the exposure to any particular asset is limited. The effect of diversification on portfolio risk, the implications for the proper measurement of risk, and the risk-return relationship are the topics of Part Two. These topics are the subject of what has come to be known as modern portfolio theory. The development of this theory brought two of its pioneers, Harry Markowitz and William Sharpe, Nobel Prizes.

passive management

Buying and holding a diversified portfolio without attempting to identify mispriced securities.

active management

Attempting to identify mispriced securities or to forecast broad market trends.

Efficient Markets

Another implication of the no-free-lunch proposition is that we should rarely expect to find bargains in the security markets. We will spend all of Chapter 8 examining the theory and evidence concerning the hypothesis that financial markets process all relevant information about securities quickly and efficiently, that is, that the security price usually reflects all the information available to investors concerning the value of the security. According to this hypothesis, as new information about a security becomes available, the price of the security quickly adjusts so that at any time, the security price equals the market consensus estimate of the value of the security. If this were so, there would be neither underpriced nor overpriced securities.

One interesting implication of this "efficient market hypothesis" concerns the choice between active and passive investment-management strategies. Passive management calls for holding highly diversified portfolios without spending effort or other resources attempting to improve investment performance through security analysis. Active management is the attempt to improve performance either by identifying mispriced securities or by timing the performance of broad asset classes—for example, increasing one's commitment to stocks when one is bullish on the stock market. If markets are efficient and prices reflect all relevant information, perhaps it is better to follow passive strategies instead of spending resources in a futile attempt to outguess your competitors in the financial markets.

If the efficient market hypothesis were taken to the extreme, there would be no point in active security analysis; only fools would commit resources to actively analyze securities. Without ongoing security analysis, however, prices eventually would depart from "correct" values, creating new incentives for experts to move in. Therefore, even in environments as competitive as the financial markets, we may observe only near-efficiency, and profit opportunities may exist for especially diligent and creative investors. This motivates our discussion of active portfolio management in Part Six. More importantly, our discussions of security analysis and portfolio construction generally must account for the likelihood of nearly efficient markets.

1 Investments: Background and Issues 11

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