Risk-Return | Efficient Market Hypothesis | Investment Process | Essentials of Investments
Channel: Farhat Lectures. The # 1 CPA & Accounting Courses
Date: 2020-06-07

In this video, I discuss, risk-return. The risk-return tradeoff states that the potential return rises with an increase in risk. Risk-Return is one of the more basic relationships in investing is between risk and reward.

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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 46% of its value. In 1933 (the best year), the stock market gained 55%. 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.4 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 any particular asset offered a higher expected return without imposing extra risk, investors would rush to buy it, with the result that its price would be driven up. Individuals considering investing in the asset at the now-higher price would find the investment less attractive. The price will 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 were independent of risk, there would be a rush to sell high-risk assets. Their prices would fall (improving their expected future rates of return) until they eventually were 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.

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 available 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.