Cogito

When High Risk is Not High Return?

Posted in CFA by qmarks on February 1, 2010

Assume you are in Las Vegas and playing different games, Roulette, Card Games etc. and you bet on many different tables at the same time, should you make more money by diversifying your risk?

Remember the CAPM

Expected Return = Risk Free Rate + Beta x Market Premium.

where higher the risk higher the return, but  wait, which risk is that ? We need to make a distinction between risks. The game in Las Vegas is similar to company specific risk which is unsystematic risk-you can not diversify your risk by adding more assets and in Las Vegas case the game tables are not correlated. On the other hand Beta is systematic (market, beta) risk. Therefore ONLY MARKET RISK  gives you HIGHER RETURN but not the company specific risk.

Since leverage magnifies the risk, regardless of the type, unsystematic or systematic one should be very careful about which risk she/he bears. Otherwise she/he ends up with “hey I am taking higher risk, and I will have higher return”

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