Understand Risk vs Return on Your Investment

As Professor David Geltner explains, in terms of real estate, no risk often means no (or, rather, much more limited) returns. So how do you decide whether an investment is worth taking on more risk? Well, it’s all about market equilibrium and expected returns.

Transcript

Imagine for a moment that you have the opportunity to invest in either one of two assets: Asset Charlie and Asset Delta. These two assets offer the same expected return. That is, over time, their returns will tend to average out the same. However, Asset Charlie is less risky than Asset Delta, meaning that Asset Delta’s returns will tend to bounce around or rise and fall more. Which one of the two assets would you invest in?

Well, if you’re like most investors, you would choose Asset Charlie, the less risky of the two since the expected return is the same. But what would happen if Asset Delta offered a higher return compared to Asset Charlie. Now, perhaps your decision is not so obvious.

Let’s take a look at how this works in the market for assets, such as stocks, bonds, and real estate. This graph shows the relationship between risk and expected return in the asset market. The line on the graph is called the security market line or SML for short. It was originally used in the stock market, but applies to all capital assets, including real estate.

Investment risk is measured on the horizontal axis and the expected return is measured on the vertical axis. The risk-free rate is the return you can get by investing in an asset that has no investment risk.

Refer back to the example of Asset Charlie and Asset Delta, investors would rather invest in Asset Charlie. Investors would try to sell Asset Delta and bid to buy Asset Charlie. Demand for Asset Charlie increases and demand for Asset Delta decreases.

This will drive up the price of Asset Charlie and drive down the price of Asset Delta. The future cash flows the assets can generate are not affected by all this bidding by investors to buy and sell. Returns are essentially future cash flows as a fraction of present price.

So, as the price of Asset Charlie is bid up, its expected return is effectively bid down. And vice versa for Asset Delta. This will result in Asset Delta, the riskier of the two assets, offering a higher expected return to investors than Asset Charlie. At a certain difference between the expected returns of the two assets, investors, on average or overall, will be indifferent between them, and the market will be in equilibrium with no pressure on either assets, price, or expected return.

The amount of difference between the two assets’ expected returns, in order to achieve this equilibrium, depends on the amount of difference in the investment risk in the two assets. And it depends on how risk averse the market is, and on investors preferences for lower risk assets. This is reflected in the slope of the line in the graph. 

Capital markets must compensate investors by pricing assets to provide higher expected returns – that is, higher returns on average over the long run on riskier investments.

The security market line can be represented graphically as we’ve shown it here, defining risk on a single dimension. Remember that the risk-free rate is the rate you are guaranteed to get on an investment that has no risk. This rate is also referred to as the time value of money, and it only compensates investors for the fact that they were allowing others to use their money over time.

The risk premium is the additional compensation in the form of higher expected return, average return over time, to investors for their willingness to take on more risk. It is the difference between the total return and the risk-free rate. The risk premium must be proportional to the amount of risk the asset is exposed to.

Looking at the graph again, you will see that, for every additional unit of expected return, the investor must take on the same additional unit of risk.

With this in mind, let’s step back a minute and view the return components relationship more broadly. It is important to note that the graph illustrates an ex-ante relationship.

In other words, the expectations the market has beforehand of what will happen with the various investments. Ex-ante investors can only increase their expected return by taking on more risk. However, in reality, the ex-post return will often differ from the ex-ante expectations. If an asset always returned exactly its prior expectation, there would be no investment risk.

This ex-post difference between the realized return and the risk-free rate is called the excess return.

In this video, you saw that riskier assets must provide investors with higher returns, otherwise investors will not be interested in buying these assets. The opposite is, however, also true. You cannot expect to receive higher returns on an investment on average, without taking on more risk.