In general, there is school of thought that if risk is higher, then probability of “returns are also higher”. On many occasions almost all investors would have used this interpretation. This is only true to certain extent, it is a partial truth. It is incomplete.
What gets missed is that higher risk (or the complexity) does not mean “higher probability” of higher returns. The implied meaning is “probability of those higher returns” is much lower. The point I am trying to make is, understanding risk-return is not that simple. Taking higher risk definitely means higher return, but the probability of those higher returns is smaller, or lesser.
I was doing some research on Indian equity market index to understand it little better so that I can increase my allocation. In the process, I came through an interesting paper on Scribd which explains my above risk-return interpretation with an example. It is only four pages so you can read it pretty quickly. Focus on Table 1 and Figure 1 which quantifies this interpretation. You may ignore that that it is for Indian equity market. continue reading rest of the article….