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The Conceptual Foundations of Investing
book

The Conceptual Foundations of Investing

by Bradford Cornell, Shaun Cornell, Andrew Cornell
October 2018
Beginner content levelBeginner
256 pages
5h 33m
English
Wiley
Content preview from The Conceptual Foundations of Investing

4RISK AND RETURN

Almost any investor will tell you that there is a trade-off between risk and return – to earn more return you have to bear more risk. Right? Not exactly. In fact, until the “risk” and “return” are defined more carefully the statement is at best largely vacuous. Worse still, it can be outright misleading.

First, bearing more risk does not necessarily lead to more return. If it did, investors would not really be bearing more risk because they could be assured of eventually getting a greater return. Instead, bearing more risk means it is more likely that you will suffer large losses. Second, all risks are not created equal. Consider betting $10,000 on the Superbowl. That is obviously risky for both you and your counterparty. But you can't both get more return from the risky bet. One person's win is the other's loss. Third, as we describe in detail below, some risks can be eliminated by diversification and others cannot. Should both types of risk be rewarded with the same return premium?

The scholars who developed the theory of asset pricing were aware of these issues. Part of their solution was to recognize that the theory only makes sense if you speak of expected risk and expected return. But already things are starting to get nebulous. Who is doing the expecting? This is not an idle question. Merton Miller tells a great story from the ceremonies at which he received his Nobel Prize in economics. As Miller recounts it,

I still remember the teasing we financial ...

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Publisher Resources

ISBN: 9781119516293Purchase book