The risk-return relationship is an essential concept to understand the economic sensibility in any investment decision.
We organize ourselves through markets, and the stock exchange is exactly that — a market. All economic acting participants in it search for opportunities that they deem best suited for them. In the struggle to find the best investment opportunity we look for a high expected return. That comes with the propability of the investment not being successful.
Within the market a structure therefore emerges were investors will request more return for their willingness to accept lower chances of success. Consider this similar to an estimated value calculated by return multiplied by the propability of the return.
The most important lesson for you to internalize is that there is always a risk to a return, no matter if you can see it or not. If you are being offered a return and cannot see any risk, it is not because it is not there. It is because you don’t see it. There are entities that are able to violate that rule and arbitrage or benefit from influence they have, but you are not among them.
Now let’s take a look at risk and return. On the stock market and especially within diversified portfolios (think ETF) return is the yield and risk is considered the deviation of stock prices around a mean, called volatility.
Coming back to our underlying priciple we should realize that volatility is not the cause for risk but only partially a result of it. To describe causality for risk let’s take a look at the core areas that we encounter as investible markets. The sovereign bonds market (debt of goverments), corporate bonds market (companies borrowing money) and stocks market (equity of companies).
Countries usually cannot go bankrupt, unless they have their debt in a foreign currency. Even if countries do not have money, they have a tax monopoly that will retain value as long as there is economic activity within the country. Corporations on the other hand are prone to market needs, the banks that give them credits, and most importantly the state they reside in. Private property is only possible through the rule of law. You will therefore rarely find companies that have a better rating than their host countries.
Looking at corporate debt (bonds) and equity of companies (stocks) we have to consider the legal differences between them. If a company goes bankrupt, there is a step by step process in which all parties that have claims against it are satsified. This is very similar to a cashflow waterfall. All claims from debt are satisfied before any of the owners receive something. By legal status there is therefore a difference in risk. This is a causality for differences in the risk profile of different investable markets.
In the overall pool of companies on stock markets we have about 43.000 companies worldwide with supposably about 16.000 that are reasonably investable. Every company has a CEO that basically has one target, to increase return on equity. So whatever someone proposes to him, the CEO will ask how much return on equity this will create. Investments and connected debt will only be considered if that generates reasonable return on equity.
In general all those CEOs can be expected to consider taking debt (Corporate bonds) only if it generates a higher return on equity (stocks). They create a distinctive return relationship between debt and equity with the equity yield being consistently higher than the cost of debt. Structurally stocks therefore have a higher expected return and higher risk than corporate bonds.
Coming from both sides shows that there is causality for a natural risk-return relationship.
As an example, let’s take a look at something that is considered ‘save’, overnight funds. Knowing what we know now, how can it be they pay you a return if it is save? Well they do because it’s not.
You give money to a bank and the bank compensates you for it. You then have a claim for yield and your money at the end of the agreed period. But where is the risk? Banks can go bankrupt. In the US as well as the EU we have a bail-in clause so banks can legally freeze and confiscate your funds for purposes of maintaining their solvency. In the EU a minimum of 8% of your funds was defined. That is why banks have to pay you and that is why it is only a relatively but not truely ‘save’ investment.
Stocks do not bear this specific risk as they are considered seperate assets, that are not owned by the bank but by you.
Lastly let’s take a look at risk within a privat investor universe of diversified portfolios. There are factors that will influence risk and return. Let’s take regional differences. With regions that bear political risks we can expect a higher expected return compensating for that risk. The same goes for smaller companies that usually have higher growth and therefore higher returns than bigger companies, but not all will make it. Therefore you can expect a higher return unless the risk actually occurs.