Question

What is the correlation between the risk of an investment and its expected return? positive, negative, or no correlation?

Answer 1

In general, we can say that there is a positive correlation between the risk of an investment and its expected return. That is investing in a high risk security will result in high expected return and vice-versa. But there is no guarantee that we will get high return by taking high risk investment. Sometimes it may lead to great financial loss. Also sometimes a less risky asset will provide you with high return. That means sometimes there occurs a negative correlation between the risk of an investment and its expected return. So it is hard to decide. But in general we can conclude that there is a positive correlation between the risk of an investment and its expected return, otherwise our portfolio theory, Capital Asset Pricing Model will not hold good.

You know that according to Capital Asset Pricing Model

Expected Return = Rf + b ( Rm – Rf )

Where, Rf – Risk free return, b – Beta,Rm – Expected return on market portfolio

Therefore, it is evident from the equation that when beta, which is one of the best measure of risk increases Expected Return also increases.