Why Riskier Assets Require Higher Expected Returns

Summary

The document explains the intuition behind the claim that riskier assets offer higher expected returns. If investors view an asset as riskier, they require compensation for bearing that uncertainty. Their reluctance to buy it at the same price as a safer asset lowers its price, creating room for a higher expected return relative to the safer alternative.

The key distinction is between an average or expected return and a guaranteed outcome. Greater expected compensation does not prevent losses; it reflects the additional uncertainty investors accept. The material offers a brief conceptual explanation rather than a quantitative model, empirical evidence, or a way to measure risk premia. Its conclusion depends on investors demanding compensation and prices adjusting accordingly, so it should be read as an economic intuition rather than a rule that every risky asset will outperform over a chosen period.

Key ideas

• Investors generally require compensation to hold assets with greater risk.
• Demand for compensation can lower a risky asset’s price and raise its expected return.
• Higher expected returns are averages, not guarantees of positive outcomes.
• The explanation is conceptual and does not quantify or empirically test risk premia.

Tags

# Intuition behind risk-return realation (Mark Joshi's concepts 1.2)


# Intuition behind risk-return realation (Mark Joshi's concepts 1.2)












In Mark Joshi's "The concepts and practice of mathematical finance" section 1.2, it is given an intuitive motivation behind "high risk high returns" claim. It goes as follows:

Given that all assets are correctly priced by the market, how can we distinguish one from another? Part of the information the market has about an asset is its riskiness. Thus the riskiness is already included in the price, and since it will reduce the price, the value of the asset without taking into account its riskiness must be higher than that of a less risky asset. This means that in a year from now we can expect the risky asset to be worth more than the less risky one. So increased riskiness means greater returns, but only on average - it also means a greater chance of losing money.

I really can't understand this. Would someone suggest the right point of view one should adopt when reading this sencence? Thanks a lot in advance for any help.

## Answer by Bob Jansen (score 2)

https://quant.stackexchange.com/a/75150

Investors want risk to be compensated, therefore they will only buy more risky assets if the price is right, that is only when they can expect more returns compared to less risky assets.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.