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Step 8: Riskese

Note the comparison to Figure 8-3, which shows a lowerrisk index portfolio comprised of 90% fixed-income funds and 10% stock funds with a narrow range of outcomes. The 100% stock fund index portfolio in Figure 8-2 experienced greater price swings but had higher returns. Over the simulated 50-year period, a dollar invested in the low-risk index portfolio would have grown to $20.85, while a dollar invested in the higher risk index portfolio would have grown to $472.43. This historical data supports the presumption that investors who have the capacity to hold higher risks are expected to earn substantially higher returns.

Not All Risks Are Rewarded Higher expected returns are the result of higher risk, but not all risks are rewarded at the same rate. Financial economists have long sought to identify the factors that explain stock market returns. With the help of CRSP, substantial progress has been made. In Step 2, I discussed Nobel Laureate William Sharpe and his Capital Asset Pricing Model (CAPM) This model explains approximately 70% of all stock portfolio returns. CAPM enabled investors to quantify expected returns based on how investments fluctuate relative to the market as a whole. It concluded that investments which fluctuate more than the market, as a whole, carry more risk than the market, and therefore, should also carry higher expected returns. Sharpe asserted however, that some investments carry increased risk without providing the trade-off of higher expected returns. To clarify, he divided risk into two categories: systematic and unsystematic. The entire market is exposed to unavoidable systematic risk,

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