Why Risk and Return Are Proportional — the Intuition of the Risk Premium
"High risk, high return" — is it true? It's half right and half a dangerous misunderstanding. Let's take apart the logic of why taking on risk can let you earn more.
Why a Risky Asset Comes to "Expect" a Higher Return
Think about it. If an asset with no risk of loss for anyone (e.g., a state-guaranteed deposit) and an asset that can swing greatly (e.g., a stock) gave the same return, there'd be no reason to buy the risky one. Everyone would buy the safe one.
So to attract people, a risky asset must offer a "higher expected return." This "extra return expected as compensation for taking on risk" is called the risk premium. The root of why stocks have earned higher returns than deposits over the long term is here.
The key is the word "expect." Taking on risk does not guarantee a return; it means you can "expect" to receive more on average and over the long term.
The return of a risk-free asset is called the "risk-free rate," and you can understand it as: expected return of a risky asset = risk-free rate + risk premium.
The Fatal Trap of "High Risk, High Return"
Many people misunderstand this saying as "if you take on risk, you'll definitely earn more." Absolutely not. Precisely, it means "just as there's a chance to earn more, there's also a chance to lose big."
Risk means "the range of outcomes is wide." If it goes well, you earn big; if it goes wrong, you lose big. A risky asset can hand you a large drawdown like -50% and years of loss duration along the way. If you can't withstand this and sell at the bottom, the high expected return ends up not as a return but as an actual loss.
And "taking on risk doesn't necessarily get you rewarded, either." Taking on just any risk (e.g., going all-in on an unproven coin) doesn't earn you a premium. What gets rewarded is "risk that can't be eliminated by diversification and that the market recognizes."
Buying a lottery ticket carries large risk, but the expected return is actually negative. It's not "risk = return"; it's more accurate that "only reasonably taken risk can be rewarded over the long term."
よくある質問
Q. So is more risk better?
No. The key is taking on only as much risk as you can bear. No matter how high the expected return, if you can't withstand the drawdown along the way and sell midway, the expected return isn't realized. Deciding first the maximum drawdown you can endure, and adjusting your risk level to match, is the starting point of asset allocation.
Q. Is there a way to keep returns while reducing risk?
Diversification is close to that method. Mixing assets that move differently can reduce overall volatility and drawdown without greatly lowering the expected return. This efficiency is sometimes compared using a "return relative to risk" metric (such as the Sharpe ratio).
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