Risk and return relationship has always fascinated portfolio managers, economists and researchers. With modern portfolio theory, it is generally assumed that risk and return have a direct relationship, i.e. higher the risk of an instrument, higher the return it is expected to generate.
Most of the modern portfolio equations and theorems are based on this assumption that return increases as risk taken increases and that higher risk instruments outperform the lower risk instruments. This relation holds true for all instruments.
Total risk associated with a product or an instrument can be broken down into credit risk, market related risk and other risks. Of these, credit and market risks are generally the significant ones. Now as the risk taken becomes larger, the buyer would want to be compensated for the higher uncertainty. This results in greater demand for the instrument and thus it gives a higher return.
The direct relation between risk and return which is generally assumed to be true, may not always hold. Empirical research has shown that during periods of crisis, low risk instruments perform much better than the higher risk instruments.
While it has been shown that during normal business cycle and during periods of price build up, higher risk instruments perform better as there is greater demand for such products, thus increasing their price and return in the short and medium term (Allison, 2011).
However, during periods of decline and bust, capital flight takes place from riskier instruments to less volatile products, thus hampering down the return of risky instruments significantly. This downward movement has been empirically shown to offset the advantage that these instruments might have had during periods of higher return.
Further, when the absolute risk of an instrument becomes too high, there is a possibility of default and zero return.
Works Cited
Allison, Davis. Does Higher Risk Really Lead To Higher Returns? Investopedia. 2011. Retrieved from http://www.investopedia.com/articles/trading/11/higher-risk-higher-returns.asp.
