Question

Which risk(s) are investors traditionally compensated for if the markets are in equilibrium, and why?

If you are an undiversified investor, with a higher than average level of ris aversion, are you systematically over-paying for your investments, and why?

Answer 1

In case markets are in equilibrium, then the securities in the market are fairly priced and then there is very little or no mispricing or arbitrage opportunities and hence investors are compensated for the unsystematic risk arising out of holding an investment in the market. This is because the investors would have entered into the investment at fair price and their return would perfectly follow the capital pricing model to compensate them for the volatility of the assets.

In case of a risk-averse investor, the return is expected to be lower than the average return of the market portfolio which has higher risk than that of the investor portfolio. Because of this it implies that to reduce risk, the investor must be paying a price premium which reduces his return. And hence it can be expected that the investor is systematically over-paying for the investments.