The Risk-Return Trade-off and Efficient Markets
Imagine there are two stocks: Stock A and Stock B with equal risk, but Stock B offers a higher return than Stock A does. Which stock would you buy? Naturally, you (in fact, every rational investor) would prefer Stock B. If everybody demands Stock B, its price will rise in the market causing the return to fall. The price will rise until the returns from equal-risk stocks are equal. Similarly, if there are equal returns from unequal-risk securities (Stock A and Stock B offer the same return but Stock A is riskier), the price of high-risk stock will decline until the return from unequal-risk securities is also brought to the same level.
Also Read: Investment Process
In general, investors attempt to minimize risk for a given level of return or to maximize return for a given level of risk. This relationship between risk and return is called the risk-return tradeoff. In other words, the risk-return trade-off is the relationship between risk and return, in which investments with more risk should provide higher returns, and vice versa. The financial markets play a key role in adjusting the prices of securities and establishing a relationship between risk and return.
An Efficient Market:
An efficient market is a market condition in which security price reflects all possible information quickly and accurately. It means all available information affecting security prices is processed quickly and efficiently such that the security price is fair. Therefore, there would be neither overpriced nor underpriced securities in the market. This happens in the market because many knowledgeable and competitive investors actively analyze and trade securities thereby eliminating profit opportunities.
The implication of the efficient market is that investors should choose a passive investment strategy instead of an active strategy. A passive investment strategy, suggests holding a diversified portfolio without spending resources for security analysis. Active investment strategy involves security analysis and attempts to search for mispriced securities. It also looks for the correct timing for buying and selling securities. Why do investors still pursue an active investment strategy if there are no profit opportunities? The answer is the market is not perfectly efficient leaving scope for creative and insightful investors.