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Noah Smith

High Risk, High Returns? Not Quite.

If anything, it's just the opposite.
Another risk-reward calculus.

Another risk-reward calculus.

Photographer: Brent Lewin/Bloomberg

For many years, investors have been told that risk and return are correlated. In a broad sense, history seems to bear that out -- the stock market, which fluctuates a lot more than the bond market, has yielded higher long-term returns. In a narrow sense, this principle -- the risk-return tradeoff -- is the basis of almost all academic theories of the value of financial assets. It makes sense, after all -- if something is risky, people generally won't buy it unless it also offers chances for big winnings. 

But how do you measure the riskiness of an asset? Finance theorists say that risk comes from big, broad factors, like the swings in the overall market. For example, take the capital asset pricing model, or CAPM. This is the most common and universal asset-pricing theory -- it garnered a Nobel Prize in economics, and it's where we get the terms "alpha" (marketing-beating returns) and "beta" (market-matching returns). This theory says that since you can diversify your portfolio, an asset's fluctuations don't really matter unless they also coincide with the fluctuations of other assets. If one of your stocks crashes but the other 39 do fine, you're safe, as long as that one stock wasn't a huge chunk of your portfolio. But if all 40 of your stocks crash together, you're in trouble (especially if you have to retire soon). An asset's true riskiness, therefore, is the degree to which it swings up and down when the whole market swings up and down.