In developing Modern Portfolio Theory, economist Harry Markowitz posited a relationship between risk and reward that exhibited a positive correlation between risk and return, like the one shown in the figure below:
The blue curve is called the efficient frontier. This line is a frontier since the points below and to the right of the line are achievable. The blue curve is efficient since if you adjust your portfolio so that the relationship between risk and reward is on the blue line then you are taking on the exact amount of risk needed to achieve the highest possible reward or return on your investment.
The development of this theory garnered Markowitz a Nobel prize and led to the modern diversified portfolio. If you invest or contribute to a 401K at work, your portfolio is influenced by this idea. The problem is that the efficient frontier, like so many concepts in economics, is not supported by empirical evidence, as reported in a recent article in The Economist. Specifically, the idea that you can achieve greater expected returns by taking on more risk has been shown to not hold up, at least for American and British equities. Over the last 40 years, the riskiest stocks significantly underperformed the rest of the market. Two lessons to be learned here
1. Don’t rely on economic theory to make you rich or even to make wise decisions about investments; and 2. Seek out less volatile stocks if you want to optimize returns while minimizing risk.