“It is clear that there is a relationship between risk and
return, but we are not yet clear exactly what the
relationship is”.
Discuss
Mohammed H. Khan
(08178887)
Kashan Rathore
(08198187)
University of Hertfordshire
MAIN REPORT
Page 1 of 13
RISK | RETURN
Table Of Contents Page No.
Acknowledgements ..........................................................3
Introduction ..............................................................................3
Risk & Return – The Esoteric Relationship.................. 3
- Define Risk ……………………………………………… 3
- What Is Equity Risk .................................. 4 – 7
- What Is Default Risk .................................... 6
- Risk & Return: Why bother with the aphetic relationship … 6
- Empirical evidence …………………………… 8 – 10
Conclusion .............................................................. 11
Reference .............................................................................. 12
Bibliography .............................................................................. 13
Page 2 of 13
Acknowledgments
We are extremely grateful to Fredrika Stahl for thoroughly entertaining us in the process of
compiling this report.
Thank you Fredika.
Introduction
It is certainly dogma that many believe the risk-return relationship is linear. But is this
statement fallacious for risk is ambiguous. This report contrives to inform the reader of what
risk exactly is in finance, the different types of risk, why investors should be concerned with
the relationship and penultimately before concluding identifies empirical evidences in
relation to risk – return.
Risk & return – the esoteric relationship?
- Defining risk
Risk is an ambiguous term, it has various definitions. In the English language risk is defined
as “the possibility of something bad happening”. (Cambridge Dictionary: 2010)
In corporate finance, Damodaran (2003) defines risk as the likelihood of a return on an
investment differing from the return one expects to make. Thus, risk not only includes bad
outcomes, that is return lower than expected but also good outcomes; returns greater than
anticipated.
Bromley (2006) suggests companies with a bigger variety of probable outcomes are
considered to be possessing higher levels of risk and vice versa.
Finance Dictionary (2010), define return as the earnings in percentage terms of the total value
of the earnings and assets that are invested.
Risk in finance can be quantified with probabilities
assigned. The method used to measure risk in finance is
standard deviation (S.D) illustrated by normal
distribution. An example to demonstrate, looking at the
two investments which both have expected returns of
10%.. The spread (uncertainty) of actual returns around
expected returns which is measured by S .D is greater on
investment A than it is on B. This means investment A is Source: Brealey & Myers:(2000)
riskier than investment B; meaning rational investors will invest in B.
Risk can be dichotomised equity and default risk. Equity risk is when cash flows are not
certain but anticipated; cash flows include capital gains and dividends. Default risk is the risk
Page 3 of 13
that firms will be unable to make the required payments on their debt obligations. To
reduce the impact of default risk, lenders often charge a rate of return that match the
debtor's level of default risk. The higher the risk, the higher the required return.
(Investopedia: 2010)
- Equity risk
Equity risk can be dissected into two, systematic risk also known as market risk is risk which
is inherent to the entire market/market segment and cannot be diversified. Factors which
affect the entire market include interest rates, natural disasters and wars. (Investopedia:2010)
Unsystematic risk otherwise known as firm specific risk is risk that is inherent in each
investment, unsystematic risk can be eradicated through diversification. An example of
unsystematic risk is news that is specific to a small number of stocks, such as a sudden strike
by the employees of a company the investor has a share in. (Investopedia:2010)
The concept of diversification is evident in the bible and fascinatingly apparent in
Shakespeare’s poem, Merchant of Venice (1596), he states:
My ventures are not in one bottom trusted,
Nor to one place; nor is my whole estate
Upon the fortune of this present year:
Therefore, my merchandise makes me not sad.
- W. Shakespeare
Shakespeare’s notion of diversification reflects the
definition of diversification in finance. Investor
Words (2010) suggest diversification is designed to
reduce exposure to risk by combining a variety of
investments, such as stocks, bonds, and real estate,
which are unlikely to all move in the same
direction:
Increasing the amount of assets in a portfolio does
eliminate unsystematic but, does not eradicate
systematic risk for systematic risk cannot be Source: Pike & Neale (2006)
eliminated as illustrated in the graph.
Source: Pike & Neale (2006)
The paragon of diversification is to
invest in assets that behave in exactly
different ways, when sales and
earnings are relatively low in one
segment and high in another. The
figure on the right demonstrates
returns from two investments, which
move in exactly an opposite way.
Page 4 of 13
The equal and opposite fluctuations in returns from the two investments give a perfect outline
for an investor who has a diversified portfolio. In exuberant economic conditions, the returns
on investment A will follow the economy resulting in prosperity. In sombre conditions,
investment B’s return will be depressed. Returns on investment B are counter cyclical; this
dampening effect on the return fluctuation is the portfolio effect (Pike & Neale: 2006)
The portfolio effect pioneered by Harry Markowitz in 1958 provides the basis from which
investors can combine the most efficient portfolio of risky assets which satisfies their risk and
return requirements hence maximising their utility. (Watson: 2007)
An eminent risk-return model based on portfolio theory, the CAPM brain child of William
Sharpe, proposes a securities return is dependent on its systematic risk. The CAPM is made
up of the following equation:
Central to the CAPM is the linear relationship known as the security market line where
systematic risk of a security is compared with the risk
and return of the market and the risk free rate of return
in order to calculate a required return and a fair price
for the security.
The CAPM infers the greater the beta of a security
which measures the volatility of the security in
relation to the market, the higher the required return
should be for the investor; for high beta stocks are
Source: Investopedia :2010
considered to be riskier (Investopedia: 2010).
The CAPM an advocate of a linear risk-return relationship adopts the doctrine of perfect
capital markets. This doctrine promulgates: investors are rational and want to maximize their
utility, investors are able to borrow and lend at a risk-free rate, all information is freely
available to investors who have similar expectations, a large number of buyers and sellers, no
one participant can influence the market, no taxes and transaction costs, no entry or exit
barriers to the market and investment occurs over a single standardized holding period.
Some of these assumptions are clearly devoid of reality, jeopardising the reliability of
CAPM. But to demean the model because of its unrealistic assumptions is nefarious, and the
adage of Sharpe that “a theory should be tested on the acceptability of its implications not the
realism of its assumptions” should be considered.
Page 5 of 13
Before analysing empirical tests of the CAPM, the makeup of the model should be analysed.
The beta of the CAPM is fallible as it relies on empirical data thus failing to incorporate new
information. For example, Investopedia (2010) reports American Electrical Power (AEP) an
electricity power supplier which was considered as a defensive stock with a low beta. When
beginning expansion the firm took on greater debt which the historical beta failed to consider.
Also, new companies tend to have insufficient price history to establish a reliable beta.
Evidently, small firm stocks have produced above average returns; however because of
insufficient empirical data, small firm stock is not accounted for by the beta. This has led to
the formation of a new CAPM but with the expansion of size and value factors which is
discussed below.
A famous critique of the CAPM, Richard Roll (1977), who declared testing the CAPM was
not possible as the market portfolio could not be observed because a perfectly diversified
market portfolio could not be created for a true "market portfolio" includes every investment
in every market, including commodities, collectibles and virtually anything with marketable
value. Those who still use the CAPM do so with a market index, such as the S&P 500, as a
proxy for the overall market.
Eugene Fama and Kenneth French (F&F)
(1992) rebut the risk return relationship put
forward by the CAPM. In their research
there was no apparent risk and return
relationship, as shown in the graph
suggesting beta appears to be of no use to
the investor.
However, F&F’s study of the CAPM has
been refuted on several occasions. An
interesting contention was made by
Source: F&F : 1992
Amihud, Christenden and Mendelson
(1992) who used the same data as F&F, performed different statistical tests, and showed that
differences in beta did in fact explain differences in returns during the time period. Chan and
Lakonishok (1993) looked at a much longer time series of returns from 1926 to 1991 and
found that the positive relationship between betas and returns broke down only in the period
after 1982. They attribute the breakdown to indexing which they argue has led the larger
lower beta stocks in the S&P 500 to outperform smaller high beta stocks. They also found
betas are a useful guide to risk in extreme market conditions, with the riskiest firms
performing far worse than the market as a whole, in the 10 worst months for the market
between 1926 and 1991.
F&F (1992) also suggested that other factors affected investment returns. They noticed small
firm stocks and stocks with high ratios of book value to market value generated above
average returns, leading them to produce the three factor model which in essence is an
expansion of the CAPM, but with the addition of size and value factors. Value stocks are
Page 6 of 13
defined as those with high ratios of book value to market value. The book-to-market ratio
attempts to identify undervalued or overvalued securities by taking the book value and
dividing it by market value. The book value is the total value of the company's assets that
shareholders would theoretically receive if a company were liquidated. The market value is
the current quoted price at which investors buy or sell a share of common stock or a bond at a
given time (Investopedia:2010)
With equity risk there is some vigour in the CAPM which purports a positive risk return
relationship.
Default risk
Investopedia (2010), define default risk as the risk that companies will be unable to make
the required payments on their debt obligations. Default risk is measured by bond rating and
is determined by the firm’s ability to produce adequate cash flows from its operations and
volatility of a firm’s cash flow (Damodaran: 2003). The firm that can generate high cash
flows to pay off their financial obligations should have lower default risk than a firm that
cannot.
If a firm’s cash flow fluctuates spontaneously, it increases its default risk. The more stable a
firm’s cash flow the lesser the default risk.
Default risk is measured by bond rating,
which is assigned by an independent
ratings agency who is paid by the
borrowers to assess their ability to
payback their debt obligations. This is
paradoxical and subject to vigorous
debate as there is a conflict of interest
between the two parties.
Generally, a bond is likely to pay more
interest if the issuer has higher default Source: Standard &
risk relative to other firms. This is
illustrated on the graph; the graph shows bond ratings and return have an inverse relationship.
(Standard & Poor: 2009).
Default risk thus conforms to the notion of a linear risk-return relationship.
Risk & return: why bother with the apathetic relationship
It is imperative that investors receive returns which match their risk profile for if they do not,
they are not managing their money well. This can adversely affect how much wealth they can
create at specific levels of risk.
Also, the risk-return relationship is characterized as being a "positive" or "direct"
relationship meaning that if there are expectations of higher levels of risk associated with a
Page 7 of 13
particular investment then greater returns are required as compensation for that higher
expected risk. Alternatively, if an investment has relatively lower levels of expected risk then
investors are satisfied with relatively lower returns. (Watson & Head: 2007)
Empirical evidence
In financial theory the idea that gains in one dimension must be sacrificed by losses in
another dimension dominates many issues, and can best be summarized by the
popular phrase “there is no such thing as a free lunch” (Sharpe: 1964). Therefore investors
have to balance return and risk according to their preferences. Intuitively additional return
must compensate investors for assuming additional risk
A positive relationship between risk and return means that a strategy with higher financial
returns is accompanied by higher financial risk, i.e. increase chance of bankruptcy. (Miller
and Bromiley : 1990). Thus it is consensus that risky strategies tend to have highly variable
outcomes and revenues resulting in extreme prosperity or loss. (Raynor : 2007) many studies
support a linear risk return relationship e.g. (Brealy and Myners: 1981, Wensley :1981 and
Miller and Bromiley:1990).
A prominent study on this topic was conducted by Conrad and Plotkin (1968) who support
the positive relationship between risk and return, which is evident in their study where they
looked at the variance of returns for a number of firms when compared to that of its industry,
and found the trend to be positively correlated.
An important foundation of the risk-return relationship is the notion that managers are
generally risk averse. This approach is well accepted in formalist theories of decision making
that are based on notions of individual rationality and maximization of utility. Agency theory,
a formalist theory, is based on assumptions of rational behaviour and economic utilitarianism
(Ross: 1973), and assumes a linear positive relationship between risk and return.
Risk behaviour has been associated with assumptions of rational behaviour, outcome
weighing and utility maximization. Financial theory suggests that risk averse behaviour is
evident when low risk is associated with low return, as well as when high risk is rewarded by
high return (Fisher & Hall: 1969). This risk averse outlook also assumes that for each
strategic alternative, firms and managers will choose that alternative which maximizes utility
(Schoemaker: 1982). This study makes the macro subject of risk return into a subjective
study. It implies risk and expected return is derived by the rational investor. It meets the
consensus that if an investment is of high risk, a high return is anticipated.
Aeker and Jacobson (1987) found systematic and unsystematic risk have a significant
positive influence on performance from a shareholders perspective. The logic behind the
argument is, firms with high unsystematic risk tend to have problems attracting better
managers that can improve performance.
The notion of a linear risk and return relationship is apparent amongst ordinary
shareholders. For when a company becomes bankrupt, ordinary shareholders are last in line
in the distribution of the proceeds of the liquidation; because they are last in line it means
there is significant risk of them receiving nothing. According to Watson and Head (2007)
since ordinary shareholders carry the greatest risk of any of the providers of long term
finance, they expect the highest returns in compensation. This infers they expect their returns
Page 8 of 13
through capital gains and dividends to be higher than either interest payments or preference
dividends.
This is also apparent in capital structure as the cost of equity curve is higher up than the cost
of debt as shareholders face financial and bankruptcy risk whereas debt holders only face
bankruptcy risk which is one reason why shareholders require greater returns. (Watson &
Head: 2007) Also, at higher levels of gearing, the risk that a firm may be unable to make
interest payments increases which is why shareholders expect greater return as gearing
increases (M&M: proposition 2: 1958).
A study conducted by Ibbotson Associates
from 1926 - 2000 shows the investment of
$1 in 5 portfolios ranging from risk free
investment (Treasury bonds) to the riskiest
kind of investment, “small cap” stocks. The
graph shows that investment in small cap
stocks were the most lucrative whilst
investment in treasury bonds was the least
Source: Brealey & Myers:(2000)
rewarding. This study advocates the linear
risk-return relationship.
Black (1993) conducted 2 studies as depicted on the two graphs.
Study 1 involves 10 portfolios invested in the New York Stock
Exchange from 1931 – 1965 each with a different beta with
portfolio 1 having the lowest beta and portfolio 10 the highest.
His study supports the CAPM supposition; the linear risk return
relationship. However in study 2 carried out between 1966 –
1991 the 10 portfolios did not conform to the linear relationship.
Justification was given for the breakdown of the relationship in
the study, which Brealey & Myers (2000) debase as outlandish.
Source: Brealey & Myers:(2000)
Study 1 and 2 combined show how over a long period 60 Source: Brealey & Myers:(2000)
years expected return does increase with beta, though less
rapidly than the CAPM suggests. The idea of a linear risk
returns relationship is best captured here – Brealey & Myers
(2000) suggest an important point; regardless of all the studies
conducted “the best one can do is to focus on the longest
period for which there is reasonable data.”
Myners (2001) suggest that returns have risen due Source: Brealey & Myers:(2000)
to other factors other than beta. These factors
include firm size and book value to market value.
The graph on the right shows returns made on
investment of small firm stocks and value stocks.
Thus in this scenario the CAPM does not hold as
beta is not the only factor dictating expected
returns. For example, during the depression era
Page 9 of 13
the value stocks were sold below book value due deteriorating market conditions; thus
investors deemed these stocks as risky and wanted to be compensated in the form of higher
expected returns.
One possible reason for why beta did not pick up the volatility of the small firm stock is,
because small firms usually have insufficient price history to establish reliable betas.
Although this idea of returns being affected by other factors; it should be made clear that the
risk return doctrine is advocated in this situation.
Scholars and cents (2002) make an interesting point regarding the risk return relationship.
They suggest based on the long term (5- 10 years) a risk return pattern emerges as advocated
above. The more risk associated to an investment the higher its short term volatility and the
higher the long term return. The notion of time horizon can be demonstrated with an
example, if one set up a college fund and has 10 years before his child begins college, the
more risk he can potentially afford to take. On the other hand if he had 1 year before his son
began college he would want to limit his exposure to higher risk investments.
To paraphrase, if the investor can afford to invest for a longer period of time, they can make
investments which have higher level of risk, which can potentially earn them great reward.
Thus, this study suggests the risk return relationship is a component of time; over a large time period
a linear risk return pattern emerges.
The way a firm implements diversification can also affect the risk-return relationship.
Rumelt (1974), Bettis and Mahajan (1985) investigated the impact of different
diversification strategies on the risk-return pattern of firms. From their results they found
firms whom implemented unrelated diversification that is a business which adds new or
unrelated product lines or markets usually have to take extreme risks for high rewards,
whereas a firm with related diversification could reduce risk and still be rewarded generously.
Bowman (1980) found a distinct and significant negative relationship between risk and
return. Examining a large sample of firms from 85 industries, Bowman found a negative
relationship between risk and return among firms that were performing well, as well as a
negative return between risk and return for firms performing poorly. Bowman's (1980, 1982)
interpretations of his findings were that managers may be risk seekers under certain
circumstances. Well-managed firms according to Bowman (1980, 1982) appeared to be able
to increase their returns and reduce risk simultaneously (suggesting an apparent paradox on
account of the negative relationship), and in contradiction with the positive risk-return
relationship postulated by the formal theorists. The paradox in the risk-return association, the
negative relationship found by Bowman (1980, 1982), where there is one group of high risk
and low return firms (the inferior performers), and another group of low risk and high return
firms (the superior performers), was also supported by other researchers (Fiegenbaum &
Thomas: 1986 )
Behavioural decision theory and prospect theory (Kahneman & Tversky, 1979: Laughunn,
Payne, & Crum, 1980) suggested that individuals are not uniformly risk averse but adopt a
mixture of risk-seeking and risk-averse behaviours depending on targets and return levels.
Returns below target, a large majority of individuals appear to be risk-seeking but if returns
are above target they seem to be more risk-averse. Using data on US firms, a negative risk-
return relationship was found for firms having returns below target level and a positive
relationship for firms with returns above target.
Page 10 of 13
Conclusion
The report has defined the risk as likelihood of a return on an investment differing from the
return one expects to make. It then went on to dissecting risk into equity and default. With
equity risk occurring when certain cash flows are not certain but anticipatedDefault risk is the
risk that firms will be unable to make the required payments on their debt obligations.
Equity risk was dissected into systematic and unsystematic risk, where diversification could
be used to eliminate unsystematic risk. A model used with equity risk to calculate the
required return on an investment was the CAPM which assumed a linear risk-return
relationship. The reliability of CAPM is still in consternation, but CAPM has shown a long
term relationship between beta and systematic risk.
Default risk advocates a positive risk return relationship. For high risk borrowers it is more
expensive to borrow than low risk borrowers; which is apparent in practise.
The profusion of empirical evidence is likely to lead to disarray. To keep comprehension
simple the more coherent arguments are put forward here. Intuitively, an investor will want to
be compensated for taking on risk. This is apparent with ordinary shareholders who are last in
the credit hierarchy so demand greater returns than preference shareholders. Also, in capital
structure, shareholders face more risk than debt holders which is one reason why debt finance
is cheaper. As well as this , when gearing increases the risk of inability for the firm to pay
interest on their loans also rises which is why shareholders expect higher returns as gearing
increases.
The study conducted by Ibbotson Associates where $1 was invested in 1926 - 2000 in 5
portfolios with different risk levels showed the return on the riskiest portfolio which
consisted of small firm stocks was greater than the portfolio which consisted of risk free
securities. A similar study was conducted by Black (1993) which shows over a long time
period (60 years) there was a linear risk return correlation.
The evidences against the positive relationship are somewhat subjective in their application.
The purpose of the study was to find out how one would expect to be compensated for taking
on risk. Bowman (1980) makes a valid point about the ability of good managers to minimise
risk and maximise return. However, instinctively a reward should be given for taking on risk,
risk can be synonymous with work; the more work one takes on the more reward he will have
earned.
The idea that the relationship of risk and return is created by the individual investor is one of
paramount interest. When the investor perceives of an investment containing high risk,
instinctively he expects a high return. This intuition of linear risk return becomes verity.
To conclude, the relationship between risk and return is linear subjectively, and according to
the studies which have been conducted over a long time period, it is also apparent
objectively.
Page 11 of 13
REFERENCE
Aaker, David A., and Robert Jacobson (1987 June), "The Role Of Risk In Explaining
Differences In Profitability," Academy of Management Journal, 30, 277-296
Bettis, R. (1981). Performance differences in related and unrelated diversified firms.
Strategic Management Journal, 2 (4), 379-393.
Bowman, H. E. (1982). Risk seeking by troubled firms. Sloan Management Review, 23 (4),
33-42.
Brealey, R. A. & Myers, B., (2003). Principles of Corporate Finance. 7th edn. New York:
McGraw-Hill Higher Education
Bromley, D. (2006) What is a Volatile Market? Available at:
[Link] [Accessed: 27th October, 2010].
Cambridge Dictionary, (2010) Risk, Available at:
[Link] [Date accessed: 12 Nov.
10]
Chang, Y., & Thomas, H. (1989). The impact of diversification strategy on risk return
performance. Strategic Management Journal, 10 (3), 271-284.
Damodaran, A (2003) Corporate Finance Theory and Practice.2nd edition. New York: John
Wiley & Sons, Inc.
Fama, E. K, French. “The Cross- Section of Expected Stock Returns.” Journal of Finance, 47
(1992), pp.427-465.
Fiegenbaum, A., & Thomas, H. (1988). Attitudes toward risk and the risk-return paradox:
Prospect theory explanations. Academy of Management Journal, 31. 85-106
Finance Dictionary, (2010) Return, Available at: [Link]
[Link]/ROI [Date accessed: 12 Nov. 10)
Fisher, N. I., & Hall, G. (1969). Risk and corporate rates of return, quarterly. Journal of
Economics, 83, 79-92.
Investopedia (2011) Fama And French Three Factor Model, Available at:
[Link] [Date accessed: 26
Oct. 2010]
Investopedia , (2010) Define Default Risk, Available at:
[Link] [ Date accessed : 30 Oct. 10]
Page 12 of 13
Investopedia ,(2010) Beta, know the risk, Available at:
[Link] [Date accessed : 29 Oct. 10]
Investopedia, (2010) Define Systematic & Unsystematic Risk, Available at:
Pike, P. & Neale, B., (2006). Corporate Finance and Investment: Decisions & Strategies.5th
edn. Essex: Pearson Education Limited. 238
Pike, R. Neale,B. (2006) Corporate Finance & Investment Decisions & Strategies. 5th edition.
Harlow: Pearson Education Limited
Roll, R. “A critique of the Asset Pricing theory’x Tests: Part 1 . On part and potential
Testability of the Theory. “ Journal of Financial Economics, 4 (1977), pp. 129-176
Shakespear, W. (1596) Merchant of Venice.
Standard and Poor – Vazza, D. (2009) The Relationship Between Corporate Credit Ratings
And The Cost Of Debt. Available at:
[Link] [Date
accessed: 26 October 2010]
Watson,D. Head,A. (2007) Corporate Finance Principles and Practice.4th edition. Essex:
Pearson Education Limited
Bibliography
Cool, K., & Dierickx, I. (1987). Negative risk return relationships in business strategy: The
case of U.S. pharmaceutical industry, 1963-1982. INSEAD working paper.
Fiegenbaum, A., & Thomas, H. (1986). Dynamic and risk measurement perspectives on
Bowman’s risk-return paradox for strategic management: An empirical study. Strategic
Management Journal, 7, 395-407.
Fiegenbaum, A., Hart, S., & Schendel, D. (1996). Strategic reference point theory. Strategic
Management Journal, 17, 219-235.
Ross, S. A. (1973). The economic theory of agency: The principal's problem. American
Economic Review, 63, 134-139.
Scolars and Cents (2002) The Risk/Return Relationship. Available at:
[Link]
risk_return.htm [Accessed: 16th November, 2010].
Page 13 of 13