What you will learn
- Explain why finance treats risk as a range of possible outcomes, not only the chance of losing money
- Describe why investors expect more return when they take more risk
- Use the risk-free rate and a risk premium to work out an expected return
- Separate market-wide risk from company-specific risk and identify which one diversification can reduce
Every investment comes with two basic questions: what might you earn, and how uncertain is that result? You saw the tradeoff in the asset ladder. Stocks have offered more reward than bonds or cash, but their returns have also bounced around more. Finance gives us a simple way to think about that relationship.
Risk and Return Basics
A nice video created by Finance and Quant Society about risk and return. Watch it before moving on!!
What finance means by risk
In everyday conversation, risk usually means losing money. Finance uses a broader definition: risk is uncertainty about the outcome. If an investment could produce returns across a wide range, it is risky. If its return is nearly certain, it is safer. Both good and bad surprises count because either one shows that the result was hard to predict. In the statistics unit, you will learn how to measure this spread.
Why more risk should offer more return
Investors need a reason to choose a riskier asset, so it must offer the possibility of a higher return. Suppose a safe asset and a risky one had the same expected return. Buyers would choose the safe asset instead. The risky asset's price would then have to fall until its expected return became attractive enough. Over long periods, stocks have returned more than bonds, and bonds have returned more than cash. That extra return compensates investors for accepting more uncertainty.
You cannot earn a return without accepting some risk. The useful question is whether the possible return makes that risk worth taking.
A baseline return and an extra premium
- The risk-free rate is the return available with almost no risk. Finance usually uses short term US government Treasury bills as the measure. Other expected returns start from this baseline.
- A risk premium is the extra expected return that investors demand above the risk-free rate. A greater risk should come with a larger premium.
Key terms
- Risk
- The amount of uncertainty or variation in an investment's possible results.
- Expected return
- The average return you would expect after weighing both good and bad possible outcomes.
- Risk-free rate
- The return on an investment considered almost free of risk, usually short term Treasury bills.
- Risk premium
- The expected return above the risk-free rate that compensates an investor for taking risk.
Put the two parts together
Short term Treasury bills yield 3 percent, which gives us the risk-free rate. Investors want a 6 percent risk premium to accept the risk of holding a certain stock. What expected return does that give the stock?
- Find the baseline. The risk-free rate is 3 percent.
- Add the risk premium. Add the 6 percent premium to the 3 percent baseline.
- Calculate the expected return. 3 percent plus 6 percent equals a 9 percent expected return.
Why it matters: Start with the nearly risk-free return, then add enough expected return to compensate for the added risk.
Work out the risk premium
An investment's expected return is 11 percent, while the risk-free rate is 4 percent. What risk premium would an investor receive?
Market risk and company risk
Some risks hit almost every investment at once. Systematic risk, also called market risk, includes events such as a recession or a sharp rise in interest rates. Owning more stocks will not protect you when most stocks fall together. Unsystematic risk, also called specific risk, belongs to one company or industry. A product recall or a factory fire fits this category. You can reduce much of this risk through diversification, which means spreading your money across enough investments that one company's bad news does not wreck the whole portfolio.
What is risk and return? (Khan Academy)
A chance at a higher return usually comes with more risk. Keep that relationship in mind as you watch the introduction.
| Type of risk | What it affects | One example | Can diversification reduce it? |
|---|---|---|---|
| Systematic (market) risk | Most of the market at once | A recession or an interest rate shock | No |
| Unsystematic (specific) risk | One company or one industry | A company scandal or product recall | Yes, in large part |
Sort each risk
Decide whether each event creates systematic or unsystematic risk.
What did diversification reduce?
Instead of owning one stock, you spread your money across 50 companies in several industries. Which type of risk have you reduced the most?
Diversification reduces unsystematic risk tied to a company or industry. It cannot remove systematic risk that affects the whole market.Which risks are worth it?
Explain what it means to take only risks that offer compensation. Why can owning the stock of just one company add risk without adding expected reward?
Write an answer before comparing it with the model response.
Model answer
Some market risk comes with a higher expected return. Company-specific risk can add danger without raising that expected return. If I hold only one stock, I take on risk that I could reduce at no cost by diversifying, so I should not expect extra reward for keeping it.
The difference between market risk and company-specific risk will matter again when you build portfolios. First, we need another basic idea: money available today is worth more than the same amount received later.