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The Risk-Return Fallacy

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  • Joachim Henkel

Abstract

We assume that in the world of business, higher risks are only taken when rewarded with higher expected returns. This supposition has been confirmed empirically using capital market data. However, accounting measures have yielded puzzling results: using the mean and variance of ROE as measures of return and risk, respectively, Bowman(1980) and other researchers find a negative relationship between the measures. There are many suggested explanations of this seemingly paradoxical result, some of which relate to model misspecifications. Surprisingly, one obvious source of an artificial risk-return “paradox” has been neglected. This is the skewness of each firm’s ROE distribution. Using data from German firms, my study finds a significantly negative skewness. This skewness alone, even if firms were otherwise identical, brings about a negative relationship between mean and variance that is comparable in size to that found in the data. Thus, it is not clear if the empirical result really stems from a negative relationship between risk and return. It could be an artifact resulting from the inadmissible ex post measurement of risk. Hence, the “paradox” is highly questionable.

Suggested Citation

  • Joachim Henkel, 2000. "The Risk-Return Fallacy," Schmalenbach Business Review (sbr), LMU Munich School of Management, vol. 52(4), pages 363-373, October.
    • Handle: RePEc:sbr:abstra:v:52:y:2000:i:4:p:363-373
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    Cited by:

    1. Li, Xu & Vermeulen, Freek, 2021. "High risk, low return (and vice versa): the effect of product innovation on firm performance in a transition economy," LSE Research Online Documents on Economics 120268, London School of Economics and Political Science, LSE Library.
    2. Ranjan Das Gupta & Rajesh Pathak, 2018. "Firm’s Risk-Return Association Facets and Prospect Theory Findings—An Emerging versus Developed Country Context," Risks, MDPI, vol. 6(4), pages 1-32, December.
    3. Farrukh Mahmood & Robert M. Kunst, 2023. "Modeling nonlinear in Bowman’s paradox: the case of Pakistan," Empirical Economics, Springer, vol. 64(5), pages 2357-2372, May.

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