Question

What advice would you give to a client who is confused about the concept that in a well-functioning market all assets will have the same reward to risk ratio? Your answer should cover the following issues: a. How would we expect that all assets have the same reward to risk ratio? b. How can an investor increase his/her returns if this holds true?

Answer 1

A well functioning market indicates that all the assets are correctly priced according to their risk-reward factor. This ensures than all the securities are correctly priced in the market and no investor undertakes a higher risk for lower expected return and vice-versa. The reward-to-risk ratio signifies that for higher risk, there is a potential higher reward and similarly lower risk would escalate to lower expected reward. In short, the ratio of reward to risk remains equal for all the assets when the market is well-functioning.

An investor can increases his/her returns either by taking higher risk or diversification. By diversification, he/she would be able to take advantage of the stock with negative or lesser than the correlation of 1. This would ensure that for a given level of risk (standard deviation), the investor has higher returns expectations than if he/she has invested in a single asset ie. without diversification.