In this blog post, we’ll explore the relationship between returns and risk, the difference between systematic and unsystematic risk, and the investment principles that determine investment returns.

Returns and Risk: A Double-Edged Sword

There’s a saying: “You reap what you sow.” While this may seem true at first glance, it’s important to note that this adage generally applies only to the realm of labor.
In any type of labor, if the results lead to earnings, you can expect a fair reward commensurate with your effort. Labor is generally a field where you are compensated according to the effort you put in.
So, what about the world of investing? Economics clearly explains where returns from investing come from: they are the reward for bearing risk. The difference in returns from a specific investment is directly proportional to the magnitude of the risk involved.
In other words, higher returns mean you have taken on a correspondingly greater amount of risk. This fundamental principle is often summarized by the phrase “high risk, high return.”

The Two Faces of Risk: Systematic Risk and Unsystematic Risk

The term “risk” used here is not mere uncertainty but a concept defined more specifically in economics. In investment theory, the source of returns is generally explained by systematic risk, which refers to market-wide risks that investors cannot avoid.
Systematic risk arises from various factors, including changes in government policy, economic cycles, interest rate fluctuations, inflation and deflation, exchange rate fluctuations, changes in the international trade environment, natural disasters, and geopolitical crises.
Since these factors affect the entire market regardless of internal issues within individual companies or industries, most investors and assets are impacted. Because systematic risk is not a problem specific to any particular company or industry, it cannot be completely eliminated regardless of the investment strategy used.
For example, trading companies are always exposed to exchange rate fluctuations, and shipping companies must bear risks such as climate change or disruptions in maritime transport. For companies that trade actively with foreign countries, political and economic changes in major trading partners are also significant variables. As such, systematic risk is difficult to control or accurately predict, regardless of the performance of the investment target itself.
In contrast, unsystematic risk stems from issues unique to individual companies or specific industries. Typical causes include internal decision-making, management strategies, organizational structure, and personnel issues.
For example, a labor strike at a specific company, the failure to develop a major new product, the termination of a key contract, an internal embezzlement scandal, or losing a legal dispute all constitute unsystematic risk.
Since these events affect only specific companies or certain industries, investors can significantly reduce unsystematic risk through diversification. Modern portfolio theory explains that it is desirable to minimize unsystematic risk by diversifying across multiple assets and, ultimately, to bear only systematic risk.
If accepting internal corporate problems were a source of high returns, it might—in extreme cases—be justified for companies that engage in moral hazard to earn higher returns. However, actual capital markets assess such behavior negatively in the long term. In other words, unsystematic risk is a risk that investors must eliminate and is not considered a legitimate source of excess returns.

How are returns linked to risk compensation?

The relationship between systematic risk and investment returns is well explained by the Capital Asset Pricing Model (CAPM), developed in the 1960s. This theory evolved through the research of Jack Trainer, William Sharpe, John Lintner, and Jan Mosin, and has established itself as one of the core theories of modern financial economics.
CAPM is a model that explains how an asset’s expected return is determined, mathematically presenting the principles by which investors evaluate asset prices. Although more advanced asset pricing models are also used today, CAPM remains a representative model that forms the foundation of investment theory and financial education.
According to this model, an asset’s expected return is calculated as follows:

Expected Return = Risk-Free Rate + Beta × Market Risk Premium

Here, the risk-free rate (Rf) is generally based on the yield of government bonds, which carry very low credit risk. The market risk premium (Rm − Rf) is the difference between the expected return of the overall market and the risk-free rate; it represents the return expected to exceed the risk-free rate by investing in the market.
Beta (β) is a coefficient that indicates how sensitive an individual asset is to the volatility of the overall market. If beta is greater than 1, the asset is more volatile than the market; if it is less than 1, the asset is less volatile than the market.
The core of this model is very clear: high returns are the reward for high risk, and the risk referred to here refers exclusively to systematic risk. In other words, if an asset offers a high expected rate of return, it means that this is a fair reward for bearing a higher level of systematic risk (beta).
Conversely, expecting high returns without bearing any risk is economically untenable. The principle commonly known in the market as “There Is No Free Lunch” applies here.

In Conclusion: What Does It Mean to Take on Risk in Investing?

In the workplace, results follow in proportion to the effort expended. In investing, however, returns follow in proportion to the uncertainty one is willing to tolerate. The uncertainty referred to here is risk, and in particular, unavoidable systematic risk is described as the key source of investment returns over the long term.
Unsystematic risk, on the other hand, is a factor that must be eliminated, and it is the investor’s crucial role to minimize it by properly diversifying their portfolio. Systematic risk, on the other hand, is a risk that investors must bear, and in return, they receive expected returns.
The conclusion is clear: “High returns are reserved only for investors who are willing to tolerate high risk.” Only when you understand and accept this simple principle can you take a step closer to grasping the true nature of investing.