Discuss the relationship between risk and return. What is the historical evidence across asset classes for the relationship between risk and return? How have historical returns differed across countries?
Risks and returns of investment are linked. Typically, the higher the potential return on investment, the higher the potential risk. Thus, a trade-off between risks and returns is essential in making investment decisions at an individual and institutional level. Ilmanen (2012) noted that investors who put their money on high return investments become aware that they can get an equivalent risk because there is no guarantee that accepting a higher risk yield more returns. Therefore, investors may decide investment diversification in order to reduce portfolio risk without sacrificing potential returns. However, certain investments are riskier than others, and investors lose more despite their expected returns. For instance, stocks have high returns because they yield a fixed amount of interest but they are riskier because if a company goes bankrupt, shareholders are paid in priority.
According to Ilmanen (2012), an asset class is a collection of investments with similar returns and risk elements. For example, foreign stocks are a class of common assets. Historical evidence across asset classes for the relationship between risk and returns is the efficient market hypothesis. The hypothesis argues that the risk and returns of a class of assets are directly related (Isaacs, 2014). The higher the risk associated with investing in a class of assets, the higher the expected return and vice versa. However, the theory does not apply in real-life situations because of imperfect information. Thus, investors are forced to deal with expected returns and perceived risks.
Also, historical returns differ across countries because every country has different political and economic risks. For instance, a country that creates a friendly investment environment has lesser risks (Brink, 2017). Also, a country that has a strong economy provides more reliable investments with lesser risks. Therefore, risks do not only vary with the expected return but also with a country where investment is made.
Brink, C. H. (2017). Measuring political risk: risks to foreign investment. Routledge.
Ilmanen, A. (2012). Expected returns on major asset classes. CFA Institute Research Foundation, 1.
Isaacs, W. (2014). Allan Gray | The theory of risk and return. Retrieved from https://www.allangray.com/latest-insights/personal-investing/the-theory-of-risk-and-return/
by EssayRoyal, Dec. 10, 2019, 5:13 p.m.