Historically high return stocks have exhibited lower risk than low return stocks--just the opposite what the SML (Security Market Line) predicts. Wall Street (and unsuspecting financial planners) has been very successful in selling main street the story that higher risk = higher reward, while the smart money knows this and is able to effectively arbitrage excess returns from low risk stocks? To what extent does this make sense? Discuss and elaborate your response.
Risk and Returns
According to Keown (2002) risk is the possibility of an unfavourable outcome. The higher the chance that an unfavourable outcome may result from an investment, the higher the degree of risk. This is in consonance with the statement that high return stocks exhibited lower risk that low return stocks. High returns from stocks are equivalent to favourable outcome. Hence, these types of stocks would attract investors because of an expectation of high returns. They are encouraged to invest in such stocks because of an expectation of a favourable outcome or a lower degree of risk. This is further explained by Principle 1 which has something to do ...
This solution discusses risks and rewards within the stock market.