Risk & Return

Ideas on Risk and Return

The ideas about risk and return belong to Harry Markowitz, who published his work back in 1952. It is said that it didn’t receive much attention at the time…

Mr. Harry observed that the returns of any company’s stocks could be described statistically as a “normal distribution.” Statistically, there will always be an average historical return and a standard deviation from that average. He noted that for investors, the higher the average return and the lower the standard deviation, the more attractive the stock would be. It was a simple yet brilliant insight.

He also discovered that combining two assets could reduce deviation if their returns were not perfectly correlated over time.

In the image below, the blue arc (which Markowitz calls the efficient frontier) describes portfolios formed with different weights of Ford and J&J stocks, more precisely, the relationship between portfolio risk and return.

The yellow dotted line shows what the blue arc would look like if the returns of these two assets were 100% correlated with each other (P=1, which is unrealistic). The red dotted segments show what the picture would look like if the correlation were 100% negative (P=-1, also unrealistic). Notice that a fully negative correlation offers the possibility of eliminating risk.

Now, let’s imagine that instead of 2 assets, we have 5, 10, or 30 assets. In this case, different combinations of their weights will produce numerous portfolios, with their corresponding return and risk points scattered somewhere between the blue and yellow dotted lines. Your task is to find a combination that places you on the blue curve. This curve represents the most efficient relationship between return and risk. However, where you prefer to be on the curve depends on your willingness to take on risk.

Moreover, on this blue curve, there is an interesting point, and there is also the possibility of achieving returns beyond this curve, which I will discuss in the next entry.

Source:

Principles of Corporate Finance, by Richard Brealey, Stewart Myers, and Franklin Allen