William Sharpe tells us that if we want to achieve higher expected returns, we must be able to both emotionally and financially be able to withstand the increased volatility that inevitably comes with higher expected returns. Risk is the source of returns.

Sharpe’s Nobel Prize winning research was his 1964 Capital Asset Pricing Model (CAPM) in which he broke down a portfolio’s risk into systematic or nonspecific risk and nonsystematic or specific risk.

Systematic risk refers to the risks of the entire market as opposed to the risks specific to one stock. These market-wide risks are tied to large scale risks like the risk of capitalism being a viable economic social system. Other risks not specific to one stock include war, recession, inflation, and government policies. If you invested in the stock market, you cannot diversify away systematic risk. It is, in fact, the risk of investing in the market system.

Nonsystematic risk refers to those risks that are specific to individual companies. Examples include lawsuits, fraud, competition and other unique circumstances related to a company. The important fact for investors to understand is that there is no added expected return for nonsystematic risk above the expected return for systematic risk. This is a very big idea that essentially says that all stocks have an expected return that is the same as the market or a market index fund return. However, those stocks have more uncertainty of the expected return.

The incremental risk of one stock (nonsystematic risk) is unrewarded risk, and therefore should be avoided by investors. However, the systematic risk of capitalism is essentially the market risk and has earned an annualized return of about 10% per year for 80 years. But, in periods of less than 10 years, the annualized returns can be very volatile and uncertain. In periods longer than 20 years, the annualized returns of each period are far more consistent than one to five-year periods.

The Trade-offs between Risk and Return

Risk and return are inseparable. This means that investors must often face bedeviling trade-offs between risk and return. There’s no way around these decisions, since they’re required in order to build portfolios. For example, sometimes investors look at short-term CD rates. They like the certainty and stability of CD returns, but they feel they need to obtain higher returns. So, these investors turn to stocks. But, when they focus on the years of negative returns, they become uncomfortable because of their aversion to losses.

The result of all this is the “eat well/sleep well dilemma.” That is, if investors want to eat well and earn higher returns with stocks, they need to be prepared to take more risk and go through the volatile roller coaster ride of fluctuations in the value of their portfolio. But if they want to sleep well, they must take less risk; that is invest in fixed-income investments such as bonds, and accept that they’ll earn lower returns. Thus, the price of obtaining greater long-term accumulation of wealth with stocks is frightening fluctuations in the value of a portfolio. There really is no free lunch in investing. It’s the same old story of risk and return trade-offs identified by Markowitz.

High risk exposure is like a scream inducing roller coaster with soaring highs and stomach churning lows. Investors should hop on a milder ride if they don’t like the extreme rush of the one they’re on.

The same concept applies to investing. However, not everybody has the capacity for such exposure to risk. Figure 8-23 shows the roller coaster like returns of five different index portfolios. The gold colored Index Portfolio 90 has higher highs and lower lows than the other lower risk portfolios. Also, note that the growth of $100,000 over 35 years is higher for the higher risk Index Portfolio 90. Figure 8-24 shows what the one index of small value stocks looks like on the same scale. These graphs provide a vivid illustration of the concepts of risk, return, and time. They are available in dynamic versions that allow movement and selection options, see below.

Click here to see the interactive chart