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3.11. Relationship between risk and return

In penultimate conclusion we touch upon the relationship between risk and return. Figure 6 shows this relationship, and it is evident that the relationship is positive, i.e. the return required increases as risk increases. This is so because investors are risk averse.

The relationship is represented by what is termed the capital market line (CML which is used extensively in portfolio literature). If investors were risk seeking, the CML would be negatively sloped.

The slope of the CML depicts the extent of additional return expected / required for additional each unit of risk assumed.

There is ample empirical evidence to support the slope of this line: money market at bottom left, bonds in the middle and equities top right. This is covered next.

relationship between risk & return

Figure 6: relationship between risk & return

3.12. Risk and return: the record

Fortunately, data is available on the risk and return relationship of the three main asset classes:

• Equities

• Bonds

• Cash (i.e. money market).

Figure 7 shows the average annual returns and the standard deviations of the asset classes for a period of 108 years (1900-2007). The evidence is indisputable: higher returns are accompanied by higher risk (= dispersion around the mean return). This fits in well with Figure 6.

RSA: average annual returns & STD (108 years)

Figure 7: RSA: average annual returns & STD (108 years)

USA: average annual returns & STD (108 years)

Figure 8: USA: average annual returns & STD (108 years)

UK: average annual returns & STD (108 years)

Figure 9: UK: average annual returns & STD (108 years)

Similar numbers are recorded for the USA and the UK (see Figure 8 and Figure 9).

It will be understood that when the averaged numbers are disaggregated into higher frequency numbers the variability of returns (risk) is revealed. Figure 10 shows the annual average returns for bonds and Figure 11 shows the same for cash. Note that the scales are the same.

SA: equities: annual returns (1900-2007)

Figure 10: SA: equities: annual returns (1900-2007)

SA: bonds: annual returns (1900-2007)

Figure 11: SA: bonds: annual returns (1900-2007)

SA: cash: annual returns (1900-2007)

Figure 12: SA: cash: annual returns (1900-2007)

3.13. Summary

Equity is held by all the ultimate lenders and certain of the financial intermediaries (particularly the retirement funds, insurers and the CISs). There are risks in holding equity and this is measured by the standard deviation of expected returns and beta. Investors are risk averse and express this by demanding more return for more risk, as reflected in the securities market line. The risk and return relationship is borne out in the risk-return records over many decades.

3.14. Bibliography

Blake, D, 2000. Financial market analysis. New York: John Wiley & Sons Limited.

Faure, AP, 2007. The equity market. Cape Town: Quoin Institute (Pty) Limited.

Mayo, HB, 2003. Investments: an introduction. Mason, Ohio: Thomson South Western.

McInnes, TH, 2000. Capital markets: a global perspective. Oxford: Blackwell Publishers.

Mishkin, FS and Eakins, SG, 2000. Financial markets and institutions. Reading, Massachusetts: Addison Wesley Longman.

Pilbeam, K, 1998. Finance and financial markets. London: Macmillan Press.

Reilly, FK and Brown, KC, 2003. Investment analysis and portfolio management. Mason, Ohio: Thomson South Western.

Reilly, FK and Norton, EA, 2003. Investments. Mason, Ohio: Thomson South Western.

Rose, PS, 2000. Money and capital markets (international edition). Boston: McGraw-Hill Higher Education.

Santomero, AM and Babbel, DF, 2001. Financial markets, instruments and institutions (second edition). Boston: McGraw-Hill/Irwin.

Saunders, A and Cornett, MM, 2001. Financial markets and institutions (international edition). Boston: McGraw-Hill Higher Education.

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