Risk Versus Return

The basic lesson of the stock market is that investors get greater average returns for taking on higher risk. What would you rather have:

1. $100,000 or

2. a 50 percent chance of getting $200,000 and a 50 percent chance of getting nothing?

Both choices give you on average $100,000. The majority of investors, however, would prefer the first choice: the sure thing. Most people dislike risk, which is why so many of us buy insurance. True, many people also enjoy gambling, but for most gambling is a form of entertainment, not an investment strategy. When most people invest, they want to avoid risk. People’s desire to avoid risk ensures that stocks pay higher returns because they are risky.

Investors can either put their money in U.S. government bonds where they are guaranteed a certain rate of return, or they can buy stocks. Stocks are much riskier than government bonds. Would it make sense to live in a world where on average stocks and government bonds gave the same return? If they did offer the same return, everyone would buy the government bonds. The only reason anyone willingly takes a chance on stocks is because on average they yield a higher return. For our economy to survive, people need to buy both stocks and government bonds. Market forces ensure that the prices of stocks adjust until investors are willing to buy both stocks and government bonds. The market induces investors to buy both financial products by giving stock investors on average higher returns.