Question

2.3 (6 points) Consider the following statement: "over the long-run, risk and return within equity markets are not related. Selecting stocks with a higher risk (i.e. higher standard deviation of the return), does not necessarily guarantee a higher return. This fact contradicts investment theory, which states that higher risk should give a higher expected return.” Critically evaluate this statement in light of the lessons we learn from the CAPM.

Answer 1

An investor has many opportunities when looking at equity markets. There are various industries/business to choose from, and there are many players within each industry who can be a potentially good investment. Various stock opportunities differ from each other in respect of two primary factors:

1) Risk in the company

2) Expected returns on investment

Every time an investor is evaluating a potential investment opportunity, he not only analyzes the merits of the business but more importantly he must decide the maximum price he can pay for that stock which is dependent to a large degree on ideal rate of returns he is looking to earn from that stock investment.

In order to decide the ideal rate of expected return from any investment opportunity, the investor looks at the underlying risk in the investment. The expectations of returns must differ for stocks that have low risks from the ones that have high risks. If the risk is high, he would not enter that stock unless he can buy the stock at a price that offers proportionately high rates of return. Therefore, the investment theories have taught us that higher the risk in a stock, higher the return.

Let's analyze the above thesis from the point of view of Capital Asset Pricing Model (CAPM):

CAPM is the most widely recognized method to calculate the required rate of return on a stock. it calculates cost of equity (Ke) as follows:

Ke = Rf + Beta*(Market risk premium)

Where,

Rf = Risk free rate

Beta = Measure of stock's risk relative to the risk in the overall market

Market risk premium = Expected return of the market - Risk free rate

As we see in the above formula, CAPM essentially calculates cost of equity based on the underlying risk in the security. It uses risk free rate and adds to it the premium that a stock must earn based on its underlying risk (beta). Beta is a measure of security's risk relative to market's risk. If beta is 1, it means that the stock's risk is equal to risk of the overall market. If beta is less than 1, it means that stock's risk is proportionately lower than market's risk and vice-versa if beta is higher than 1.

Beta is multiplied to the premium that the overall market is expected to earn over risk free rate of return. This gives us the premium the stock must earn over the risk free rate based on its underlying risk.

Higher the beta (risk) of a stock, higher would be its cost of equity / required Rate of return as per CAPM. Lower the beta (risk) of a stock, lower would be its cost of equity / required rate of return as per CAPM. Therefore, it can be seen that CAPM model is based on the investment theory that higher the risk in a stock, more should be the expected rate of return.

Analysis of statement and conclusion:

The statement given in the question says 'Over the long-run the risk and return in equity markets are not related. Selecting stocks with higher risk doesn't necessarily guarantee a higher return'.

While selecting an individual stock with a high risk definitely doesn't guarantee a high return in that stock, but in the long run valuing stocks based on its risk profile and hence paying a price which gives risk-adjusted returns on investment will generate the returns accordingly. A well diversified and large enough group of high-risk stocks invested in during a long period of time will generate higher returns proportionately to the underlying risk.

Based on above discussion and analysis of CAPM, it can be said that the statement given in the question is not correct and risk in a security does determine the expected returns by an investor.