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Rekenthaler Report

There's More to Expected Return Than Risk

Rethinking investment convention.

Embracing the Ugly
Early on, MBA investments textbooks have a chapter on risk and return. The authors quickly explain that higher expected returns are related to higher risk, for the common-sense reason that investors demand a benefit in exchange for accepting a drawback. The authors then spend the bulk of the chapter detailing "risk" and "risk/return" calculations that are based upon a security's price fluctuations.

That treatment is useful, but it is incomplete. What, after all, is this thing called risk? It certainly is not identical with volatility, despite the textbook's assumptions. For example, low-grade municipal bonds are less volatile than top-quality credits, because low-grade munis trade infrequently. Sticky prices might reduce standard-deviation estimates, but they don't make assets safer. They only make them mispriced.

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