Monetary Phenomenons

I recently attended an industry conference for equity funds where the relationship of rate of return to risk, and supply and demand was brought into question. Funds were primarily attributing their increased offered rate of return to the decline in investor demand for their product. Some Funds were however suggesting that a higher rate of return may imply higher overall risk.

Rate of return for investments typically correlates positively to the underlying risk of the investment. While this premise seems accurate, it should only be applied under constant circumstances. At any given time it would be fair to evaluate different investments’ risk based on their return as long as external monetary factors are held constant. Investors try to measure this risk by using a risk premium, the additional return they require over risk-free investments.

If outside monetary factors such as the supply of money are changing, risk premiums under one set of circumstances are not comparable to those of another monetary situation. When the supply of money is reduced as it has been during the current credit contraction, returns will be greater for that reason alone regardless of investment risk. This is a relationship that was developed by Milton Freedman in his book Capitalism and Freedom where he explains why inflation is purely a monetary phenomenon.