Not All Risks Are Rewarded

Higher expected returns are the result of higher risk, but not all risks are rewarded at the same rate. Financial economists have long sought to identify the factors that explain stock market returns. With the help of CRSP, substantial progress has been made. In Step 2, I discussed Nobel Laureate William Sharpe and his Capital Asset Pricing Model (CAPM) This model explains approximately 70% of all stock portfolio returns. CAPM enabled investors to quantify expected returns based on how investments fluctuate relative to the market as a whole. It concluded that investments which fluctuate more than the market, as a whole, carry more risk than the market, and therefore, should also carry higher expected returns. Sharpe asserted however, that some investments carry increased risk without providing the trade-off of higher expected returns. To clarify, he divided risk into two categories: systematic and unsystematic.

The entire market is exposed to unavoidable systematic risk, such as war, recession, inflation, and government intervention. In contrast, unsystematic risk refers to threats specific to individual companies, such as lawsuits, fraud and competition. A summary of these different risks is presented in the top portion of Figure 8-4. Systematic risk, or the risk of investing in capitalism itself, has rewarded investors with an approximate 9.6% total U.S. market annualized return over the last 86 years (6.1% above the risk-free rate). However, an investment in unsystematic risk, such as buying individual stocks, does not increase expected returns. Unsystematic risk should be avoided through diversification, thereby maximizing portfolio efficiency and expected returns at each level of risk.

Figure 8-4

Figure 8-5 illustrates the lack of increased expected returns when investors accept the additional concentrated and unsystematic risk of individual stocks relative to their designated index. The additional risk of buying individual stocks does not increase expected returns.

Figure 8-5

Step 8William SharpeCapital Asset Pricing ModelCAPMSystematic riskcapitalismUnsystematic risk