Question

Explain why in the long-run the rate of return on investments reflects the riskiness of those investments?

300 words long!!! Do not plagiarize!! Follow directions!!!

Answer 1

Consider Three types of investments

A) 5 Year Annual coupon Government Bonds Redeemable at Par - Coupon rate 3%

B) 5 Year Fixed Deposit with a Bank - Interest rate 5%

and

C) Investment in a Mutual Fund with a lock in period of 5 Years - Historical return 15% PA

Now of all the investments mentioned above are for same period of time that is 5 years which is a long term, nut still the rate of return for all of them are different

for government bond the return is as low as 3 % because this rate is risk free, which means there virtually no chance of default in payments for this bond

similarly fixed deposit is also a safe investment but still the chances of default is high than govt bonds so a higher rate of return is expected

For a Mutual fund investors gain money in the form of dividends or in the form of appreciation in the fund unit value, certainty of which is not guaranteed hence a higher return is expected as the historical return is 15% which shows the higher expected return

The point to be made is that a rational investor needs compensation in accordance with the risk borne by him/her

for a risk free government bond where there is no chance of default the rate of return is very low , wherein the mutual fund where the chances of fund value becoming 0 is there and there exists a possibilty where the investor can lose all the money,

so for this higher risk higher compensation is required ehich is given in the form of return in investments

Another point or perspective can be a very high return or abnormal return on any asset may signal a bubble or the volatility of a particular asset

consider bitcoin

Bitcoin gave substantially high return for a long period of time , and this continued wherein more and more people started trading in bitcoin with the same expectation of high returns,

but exceptionally high value of bitcoin was actually an indication a bubble which when burst led to huge losses for the investors

so in the long run a high return asset may indicate its vulnerabilty to fall