A random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing

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REAPING REWARD BY
INCREASING RISK
Theories that are right only 50 percent of the time are less
economical than coin-flipping.
—George J. Stigler, 
The Theory of Price
A
S EVERY READER
should know by now, risk has
its rewards. Thus, both within academia and on the Street,
there has long been a scramble to exploit risk to earn greater
returns. That’s what this chapter covers: the creation of
analytical tools to measure risk and, with such knowledge,
reap greater rewards.
We begin with a refinement to modern portfolio theory.
As I mentioned in the last chapter, diversification cannot

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eliminate all risk—as it did in my mythical island economy—
because all stocks tend to move up and down together. Thus,
diversification in practice reduces some but not all risk. Three
academics—the former Stanford professor William Sharpe
and the late finance specialists John Lintner and Fischer Black
—focused their intellectual energies on determining what part
of a security’s risk can be eliminated by diversification and
what part cannot. The result is known as the capital-asset
pricing model. Sharpe received a Nobel Prize for his
contribution to this work at the same time Markowitz was
honored in 1990.
The basic logic behind the capital-asset pricing model is
that there is no premium for bearing risks that can be
diversified away. Thus, to get a higher average long-run rate
of return, you need to increase the risk level of the portfolio
that cannot be diversified away. According to this theory,
savvy investors can outperform the overall market by
adjusting their portfolios with a risk measure known as beta.