While this should be very basic, the risk-reward concept does not make sense in my mind.

I don't understand why the premium offered to offset the risk of an investment is not decreased, on average, when the investment lose money, which is more frequent when the risk is higher, leading to a null return on average?

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    For those voting to close this question please specify why you think it is off topic. The question is asking about risks involved with investments - how is that off topic? – Victor Dec 15 '16 at 2:17
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    @Victor - for what it's worth, the 2 votes so far cite "questions on economics". I agree with you and voted to leave open. I look forward to your answer. – JTP - Apologise to Monica Dec 15 '16 at 10:49
  • Could we move it to economics community instead of closing it then? – MarinD Dec 15 '16 at 11:35
  • @MarinD not anymore. Leave the question here as it is. It was voted open, and you cannot cross post questions in different stacks. Since this question already have an upvoted answer, you should not delete the question either. – Mindwin Dec 15 '16 at 21:12
  • If you need clarifications / improvements from the answers, use the comments of each answer. – Mindwin Dec 15 '16 at 21:12

Risk in finance is defined as standard deviation of returns. This is a measure of size of your returns, both negative and positive. Since the mean return is positive (at least for the stock market and fixed income), if you double the standard deviation your mean return also doubles along with it. In this way you are compensated by the market for taking on more risk.

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  • Would this mean that other instruments with null mean return (such as forex) is not following this rule? A riskier investment on forex (options on foreign currency for example) does not have any premium incentive for investing in it instead of cash forex? – MarinD Dec 15 '16 at 17:23
  • Forex does not have a null return. It has a carry which can be positive or negative (depending on which side of the pair you're holding), just like stocks or bonds. – SMeznaric Dec 16 '16 at 9:22
  • For those assets that really have no carry, such as gold for example, they are purely speculative assets. People hold them because they perceive a positive expected return not because there is one built into the asset itself. – SMeznaric Dec 16 '16 at 9:48

In an "efficient" investment market the amount of risk premium would EXACTLY offset the likelihood of loss, such that over long time frames the expected return on investment would be equal for all investment options.

In practice, we usually see that riskier investments yield a higher long-term return because the risk premium is larger than that "efficient" amount. This is because many investors don't have a long-term time horizon, and the pain of loss is greater than the reward of gain ("asymmetric preferences").

It's also important to think about the risk-reward interaction as being PERCEIVED risk to EXPECTED reward. If I'm lending money to somebody who is likely not to pay me back, I'd want a better deal than if I were lending to somebody who is certain to pay.

I think that addresses your confusion, but if I misinterpreted what's puzzling you, please let me know and I

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  • Thank you for your answer. Your first paragraph is exactly what my question is about. Put in another way: does the risk premium EXACTLY offset the likelihood of loss? Your answer (which is yes in an efficient market) is still not really clear for me: if the market is efficient, what incentive have the investors to invest in risky assets if there is no greater gain (neither loss) to do so? Is it just a random choice then? What about portfolio theories, like Markowitz? They are based on an efficient market hypothesis, but they see premium on risk as an incentive for investors, don't they? – MarinD Dec 15 '16 at 8:08
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    First paragraph is incorrect. The risk premium is paid continuously so twice as risky products would have twice the expected return but also higher likelihood of loosing money in any given period of time. Risk measures volatility both on the upside and the downside, it's another word for "how much is this investment moving"? What is equal in efficient markets are risk adjusted returns for all investment options. – SMeznaric Dec 15 '16 at 9:30
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    @SMeznaric That's an equivalent way of stating what that first paragraph is attempting to. If you are twice as likely to lose money but your return is twice as high, then over long periods of repeated investment, returns will be similar. Risk premium beyond that amount is a function of imperfect information and inefficient markets. The incentive to invest in risky assets arises from two factors: 1) Markets in the real world cannot be perfectly efficient -- some ivestors will have (or believe they have) information on risky assets that the market isn't pricing in. (to be continued) – JakeFemminineo Dec 15 '16 at 16:10
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    2.)Products with low risk have a high demand, and the presence of many buyers increases price and thus lowers return. As this happens, higher-risk products remain at a low price, meaning that the return on them will remain higher. – JakeFemminineo Dec 15 '16 at 16:12
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    @JakeFemminineo No not really. Over a long term investment that's twice as risky will yield twice the return. Risk adjusting the return means that you divide your investment returns with risk. If you do that then returns will be the same. But you actual dollar return will be double. Efficient market is still expected to compensate you for risk. Regarding your point (2), actually it appears the opposite is true, might be worth googling low beta anomaly. – SMeznaric Dec 15 '16 at 16:57

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