nisiprius wrote: ↑Tue Sep 04, 2018 5:52 am

Because you don't

*need* to take it. You can diversify this risk away. Why should

*unnecessary* risk be rewarded?

See, for example, Chapters 8 and 9 of Burton Malkiel's book,

*A Random Walk Down Wall Street*.

Always with the proviso that this is theory which may or may not be true in the real world, you have to start by asking why risk should be rewarded in the first place.

Suppose you are at an auction and people are bidding on three items. Here is a key point:

*people are only allowed to make one bid at the auction, and there will only be one auction of this kind, or anything like it, ever.* Assume that the bidders are rational, there is no sentimental value, they are traders who expect to sell the item again at some point, and they are in it to make money. But this is a once-in-a-lifetime maneuver, they aren't going to auctions like this all the time.

Item X is a transparent plastic box, essentially worthless in itself, but containing a $100,000 in guaranteed-genuine $100 bills.

Items Y and Z are opaque boxes. They come with a legal document that says that

**one** of them contains $200,000, but not the other, and nobody knows which.

I hope we can agree that the true value of box X is $100,000.00, and that if bidders are calm and rational, the auction price will be

*very* slightly under $100,000.00 (minus whatever razor-thin difference is needed to motivate people for their time and trouble). Maybe people demand an 0.1% profit even though they are taking no risk, so the final auction price might be $99,900.

What about box Y? Your mathematical expectation is exactly $100,000.00, but it's

**not a sure thing**. You aren't in it for the thrill, and you don't have any inside information or hunches that let you guess which box contains the $200,000. I don't think you want to bid $100,000 or anything close to it. A 50% chance at $200,000.00 isn't worth $100,000.00

*if you only get to do it once in your life*. You want to be compensated for taking the risk. That means that, sure, you might take a shot at it and put in a bid of $90,000, because your mathematically expected return is $100,000 or +11.1% over your bid. However, as the bidding gets higher and higher, you and everyone else will drop out long before the price reaches $100,000, because the bidders

**demand to be compensated for their risk**. Depending on what other opportunities are available elsewhere,

**you might actually be the high bidder at $90,000.** You might actually get a box with a 50% chance of $200,000 in it for $90,000. It's

**possible**.

The reason this is true is that I've set up a situation where people

**were forced** to take the risk, and demanded to be compensated for it.

Now, consider a new auction with new rules: you're allowed to make as many bids as you like. Unfortunately, all personally have with you is your life savings of $100,000 with you, while your competitors have unlimited money. (That, by the way, is one thing about our hypothetical system that is quite a lot like the real world).

As before, the true value of box X is $100,000 and the bidding will almost reach $100,000, maybe $99,900.

As before, the mathematically expected value of box Y is $100,000, but this time, there is a difference. All of your competitors are able to

*diversify away their risk* completely by bidding on both box Y and box Z.

**They** are guaranteed to get $200,000.00, sure thing, by doing this. What is going to happen? Obviously, the price on each box will get bid up to almost exactly $100,000, maybe $99,900. For the bidders who can afford to diversify,

**there is no longer any risk**.

But, you are sitting there with only $100,000, unable to bid on both boxes Y and Z. For you, then, the situation is the same as in the first auction. If, based on whatever personal equation you use for pricing risk, you were only willing to bid $90,000 then, you should only be willing to bid $90,000 now, because it is exactly the same situation for you as it was before.

So, there you are, sitting there, and you say, "Hey! I am taking more risk than everyone else, I deserve to be compensated for that risk! I am bidding $90,000 and I expect everyone else to drop out of the bidding, it's only fair!"

And everyone else is going to say "Sorry, that box may only be worth $90,000

**to you**, but it is worth $100,000

**to me** and I'm willing to bid up to $99,900. Tough."

So, in theory, equilibrium, rational investors, blah blah, most people in the stock market are diversifying, and are therefore taking less risk than people who aren't, and are therefore willing to pay more than people who aren't. And, the stock market being an auction, the prices rise to what most people are willing to pay. And in the mass that represents the prices that reflect the lower risk experienced by investors who can and do diversify.

The point is this. You hypothetically hold only, was it Apple and Amazon? As an investor in the Vanguard Total Stock Market Index Fund, I hold Apple, Amazon, and 3,562 other stocks. I have "only" the general risk of the stock market as a whole. IMHO that's a lot of risk, but you, obviously are taking more risk than I am. However, you and I pay

**exactly the same** $2,012-or-whatever/share for Amazon stock.

We are paying exactly the same price for exactly the same stock. Just why or how is it that you think you are going to get an extra reward for putting all your eggs in two baskets, when you don't need to? Do you think a broker is going to say "I see you have decided to take a gamble so I am going to give you a discounted price that stock so that you will be justly rewarded for your extra risk?"

That's the theory, anyway.