One of the most common assumptions in investing, and more broadly in any financial field, is that higher risk equals higher returns. This is one of the largest hurdles for new investors and one of the largest misconceptions when it comes to investing. While there does exist some truth to that assumption, higher risk doesn’t always mean higher returns. So, if there are different risk and return profiles for different assets is possible to find the lowest risk, highest return asset?

In order to answer this question, one would need to quantify risk which is in and of itself is a difficult task, especially when considering random events like the pandemic. One of the most common and frequently used examples of quantifying risk is a stock’s “beta”, which is in a sense an antonym for the more common term “alpha” which is used to describe excess returns. Beta is a numerical representation of a stock’s risk and volatility as compared to an index which most commonly is the S&P. The value of beta ranges from zero to about five, zero meaning extremely low risk and volatility, one meaning the same risk and volatility as the index, and larger than one being riskier and more volatile than the index. This numerical representation of risk is typically used to analyze individual stocks for comparisons of risk and returns, but in this analysis it will be used as a comparison for an entire index. The chart below plots annual returns and beta for the individual stocks in the Russell 2000.

The Russell 2000 is used in this analysis because it considered to be a much more robust index of markets, and most importantly is not the index the stocks are compared to, although there is most likely some overlap. This chart shows that there is little or no association between beta, risk, and returns, and it appears that the highest performing stocks are the ones closer to the index it is compared to. This can partly be attributed to the fact that investors are usually risk averse, since stocks are both valued by earnings and market value, or how desirable it is to investors. A risky or highly volatile stock is less likely to be bought than a conservative one which makes the price increase, and therefore creates a higher return.

So, in a sense investors create their own risk, meaning that the “riskier” stocks are not bought creating lower returns and the more “stable” ones are considered desirable creating higher and most likely more stable returns. This means that in some cases higher risk doesn’t necessarily create higher returns and in some cases it is the opposite. Another data point to analyze when considering risk is the company’s sector which can the stock inherently risky or inherently stable. In the chart below it is the same dataset from before but averaged for each sector and the size of each point is the size of sector.

This chart illustrates the point made earlier about inherent risk in sectors, with oil and energy at the high end of the risk spectrum at almost double the risk and volatility of the index it’s compared to, and utilities at the bottom. Another meaningful characteristic of this chart is that it once again shows that the riskiest investment may not come with the best returns in fact in this dataset the “riskiest” sector had roughly the same return as the most conservative one. This chart also highlights that the majority of sectors and stock’s beta are between 1 and 2 meaning that on average individual stocks fluctuate a little more than the index, which demonstrates the power of diversification. Although the majority of the sectors in this chart fall between the same risk profile the returns are highly varied ranging from five percent to twenty percent, and while this is not indicative of long term performance it does give a good idea of the relative performance of different sectors. One sector in particular that stands out is Medical (Healthcare) this is not only one of the largest sectors but also has one of the highest returns, and this of course can be attributed to the massive amounts of medical innovation and investment over the course of the pandemic.

While this chart does provide some clarity into how different parts of the market compare in risk and return profiles, it does not provide an all-encompassing framework for risk in the market. The beta values that we use only quantify additional risk apart from the index meaning that although one may seek the lowest beta stocks in an effort to gain a stable return there is still large amounts of risk despite having less fluctuations than the index. So, although there may be different risk and return profiles for different asset classes, one does need to engage in additional risk to achieve a slightly higher return. That in mind there is still always risk in investing and if the pandemic has taught us anything it’s not to have all your eggs in one basket, because things can change drastically at any moment.