Question

Your friend Lily took a finance class and learned about the risk-return trade-off. Wanting a high return, Lily invested in a risky, start-up technology company. A year later the company went bankrupt and Lily lost her entire investment. Lily is furious with her finance teacher for misleading her, claiming she was taught that higher return goes with higher risk. Explain how Lily misinterpreted the risk-return trade-off.

Explanation in details

Answer 1

Firstly, it is only one investment she is basing the entire cricticism on. The tradeoff implies that if one can tolerate the risk, he should statistically on average get higher returns.

Secondly, it is true that higher return goes with higher risk. What it means is that there is a higher chance of getting higher positive returns but again higher chance of getting higher negative returns (or losses) as well. Therefore, it is high risk. The higher positive return is not guaranteed. Because if it were guaranteed, it wouldnt be risky at all.

Thirdly, one should consider the high risk and hence pay lower price. Lower price basically increases the chance of higher returns.