What is the effect of the risk-return trade-off on the market value of common stock?

Answer 1

In the investment world, returns go hand-in-hand with risk - no matter what the investment type.

Basically, the idea is that you would invest in something, but want to be compensated in returns for something that is riskier.

On one end, you can get the sure thing - no risk. That's called the risk free rate. Generally, it's the 30-year T-bond, but you could also use money market as the rate. You could invest in lower rates, but that's just wasting your money. For example, why keep money in checking that earns almost no interest when you can make money for no work and no additional risk?

As you get riskier and riskier investments, investors generally want to be compensated for the risk they are taking on. Let's assume that the expected return was on the "Y" axis and risk - let's call it the standard deviation of expected returns - on the "X" axis. As you moved up the risk profile, you want more and more rreturn. As you moved from left to right on the X-axis, you'd start with risk-free rate, go to state bonds, currencies, corporate bonds, high yield bonds, mutual funds, real estate, individual stocks, commodities, individual businesses, art and so on.

Here's the rub. You can invest in anything you want, but some things just aren't worth the risk. For example, diversified art portfolio return about 7% compound annual rates over time. However, art comes in big boom and bust cycles - and even permanent swings out of favor. Take this compared to stocks, which have annual returns of about 11% per annum (including dividends) but with less risk. Hence, why would you invest in art rather than stocks? The answer is you wouldn't except to enjoy the art for the sake of art - which is exactly what private bankers tell their clients. It's not a great investment vehicle by itself.

So people will naturally invest in things that have the highest return for the given risk. Anything below it is not really a good investment. As people flock to the better investment, returns get lower as the price rises and expected return drops.

The bottom line is that the risk-return trade-off ensures that investments are at or near their proper place - including common stock investments. In economics, this is called the "capital efficiency frontier"