Thursday, January 7, 2010

Understanding Risk-Return

In general, there is school of thought that if risk is higher, then probability of “returns are also higher”. On many occasions almost all investors would have used this interpretation. This is only true to certain extent, it is a partial truth. It is incomplete.

What gets missed is that higher risk (or the complexity) does not mean “higher probability” of higher returns. The implied meaning is “probability of those higher returns” is much lower. The point I am trying to make is, understanding risk-return is not that simple. Taking higher risk definitely means higher return, but the probability of those higher returns is smaller, or lesser.

I was doing some research on Indian equity market index to understand it little better so that I can increase my allocation. In the process, I came through an interesting paper on Scribd which explains my above risk-return interpretation with an example. It is only four pages so you can read it pretty quickly. Focus on Table 1 and Figure 1 which quantifies this interpretation. You may ignore that that it is for Indian equity market.

NIFTY Expected Returns for Different Trading Time Scales

Based on the Table 1, you can observe that the likelihood of negative returns tends to reduce are the duration increases. Similarly, the histogram and scatter diagram also show that probability of higher returns increase as the trading duration increases.

The point is chase high risk? Why not go for less risk and less return which has higher probability of good returns?

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