Higher risk = higher return?
Generally speaking, when you take higher risk (greater standard deviation, or sigma), the expected value of your return is higher. That is, if you live a million lifetimes, you will most likely enjoy a high rate of return. Unfortunately, you get only one life, thus your return can be significantly less than the expected value. This is the same idea as the law of large numbers. When your sample size is small (1 life) it just depends on how risk-averse you are. Essentially, you are gambling.
Thus don’t expect higher returns just because you are taking more risk.
MFE classes have just begun. I am taking a course on Empirical Finance and the professor, Rossen Valkanov, is probably the most intelligent professors I’ve ever had in my academic career. He is a professor at UCSD’s Rady School of Management. If things continue to be interesting, I may finally be able to leave the quarter-life crisis. That’s a big IF.
on March 27th, 2008 at 3:46 am
hrm I talked to that guy before when I was trying to recruit him to be an advisor for the UCSD business plan competition haha.
on March 27th, 2008 at 8:50 pm
I’ve always debated the higher risk higher expected return theory. Remember, this is still a theory. Imagine you are selling short a stock. The potential for gain is limited to only 100% (theoretically) while your potential for loss is limitless (the stock goes to infinity theoretically). Therefore the risk/return ratio for selling short should dictate that no one would ever sell short (completely falls off the ‘theoretical’ risk/reward efficiency curve). The same can be said vice versa for buying stocks long.
Another reason why I don’t like the theory of higher risk/return is the way people are measuring risk. Most people use standard deviation. Mandelbrot has stated that this can be incredibly misleading. What is important is your DISTRIBUTION. Most people assume a normal, standard distribution curve. However, Mandelbrot has proven that the volatility of the market definitely does NOT follow this standard curve. There are incredibly wild gyrations and “shifts” that occur more frequently than traditional theory dictates.