In this blog post, we’ll explore the relationship between returns and risk, the difference between systematic and unsystematic risk, and the principles of investing.

Returns and Risk: A Double-Edged Sword

There is a saying: “You reap what you sow.” While this seems true at first glance, it’s important to note that this adage applies only to the realm of labor.
In any type of labor, if the results can be converted into income, you can expect a fair reward commensurate with your effort. Labor is generally a field where you receive compensation proportional to your effort.
So, what about the world of investing? Economics provides a clear answer to where investment returns come from: the assumption of risk. The difference in returns from a specific investment is directly proportional to the magnitude of the risk involved.
In other words, higher returns mean you have taken on greater risk. This fundamental principle is often summarized as “High Risk, High Return.”

The Two Faces of Risk: Systematic Risk and Unsystematic Risk

The “risk” referred to here is not mere uncertainty but a more specific economic concept. It generally refers to systematic risk, which denotes market-wide risks that investors cannot avoid.
Systematic risk arises from various factors, including changes in government policy, structural fluctuations such as economic cycles, interest rate changes, inflation and deflation, exchange rate fluctuations, shifts in the international trade environment, and natural disasters or geopolitical crises.
These factors affect the overall market regardless of the internal conditions of individual companies or industries, impacting all investors and assets. Since systematic risk is not limited to a single company or specific industry, it cannot be completely avoided no matter what strategy is employed.
For example, trading companies are always exposed to exchange rate fluctuations, and shipping companies must bear the risk of delays caused by maritime theft or climate change. Companies that trade with the United States cannot ignore political events in the U.S. As such, systematic risk is difficult to control or predict, regardless of the performance of the investment asset itself.
In contrast, unsystematic risk stems from issues unique to individual companies or specific industries. It is caused by factors such as internal decision-making, management strategies, organizational structure, and personnel issues.
For example, a labor strike at a specific company, the failure to develop a major new product, the termination of a key contract, internal embezzlement, or losing a legal dispute all fall under unsystematic risk.
Since these events affect only a single company or a specific industry, investors can effectively eliminate unsystematic risk through diversification. Portfolio theory emphasizes that it is desirable to reduce unsystematic risk and retain only systematic risk by diversifying investments across multiple assets.
If high returns were possible due to internal corporate issues, then, in extreme cases, companies engaging in moral hazard might potentially generate even greater returns. However, capital markets react punitively to such behavior. In other words, unsystematic risk must be eliminated and cannot serve as a legitimate source of high returns.

How are returns linked to risk?

The link between systematic risk and investment returns can be found in the Capital Asset Pricing Model (CAPM), which emerged in the 1960s. This theory was developed by Jack Treynor, William Sharpe, John Lintner, and Jan Mosin, among others.
CAPM explains how an asset’s expected return is determined and mathematically models the principles by which investors assess asset prices. It is considered a cornerstone of modern financial theory and is widely used in portfolio construction by both individuals and institutions.
According to this model, the expected return on an asset is calculated as follows: Expected Return = Risk-Free Rate + Beta × Market Risk Premium.
Here, the risk-free rate (Rf) is generally based on the yield of 10-year U.S. Treasury bonds, which represents the return that can be earned without taking on any risk. The market risk premium (Rm – Rf) is the difference between the overall market return and the risk-free rate; it represents the reward for exceeding the risk-free return by investing in the market.
Beta (β) is a coefficient that indicates how sensitive an individual asset is to overall market volatility. If beta is greater than 1, the asset has greater volatility than the market; if it is less than 1, it is less sensitive.
The core of this model is clear: high returns are the reward for high risk, and this risk refers solely to systematic risk. In other words, if an asset offers a high rate of return, it is a justifiable reward for assuming higher systematic risk (beta).
Conversely, expecting high returns without assuming risk is economically untenable. The principle that “there is no such thing as a free lunch” applies in the market.

In Conclusion: What Does Risk-Taking Mean in Investing?

In labor, results follow in proportion to the effort expended. In investing, returns follow in proportion to the uncertainty endured. The uncertainty referred to here is risk, and in particular, unavoidable systematic risk is the true source of returns.
Unsystematic risk, on the other hand, is an element that must be eliminated, and it is the investor’s role to minimize it by diversifying holdings effectively. On the other hand, systematic risk is the investor’s responsibility, and returns are the reward for bearing it.
The conclusion is clear: “High returns are granted only to investors who bear high risk.” Only when you understand and accept this simple principle can you take a step closer to the essence of investing.