In an efficient market, security prices adjust so that expected return is commensurate with risk. Investors bid up the prices of low-risk assets and bid down the prices of high-risk assets. Market efficiency therefore implies that if you spot an asset with an extraordinarily high expected return for its asset category, it probably carries an extraordinarily high degree of risk. If, for instance, you invest in a corporate bond with a high quoted yield, it is almost surely more risky than an average corporate bond. Even though United Airlines had an investment grade rating less than two years before it declared bankruptcy, the calculated yield on their bonds was among the highest in that rating class.

Investors, anticipating the possibility of default, drove down the price of United’s bonds to the point where the risk and expected return were in line.

Another example of the strong tie between risk and return is the experience of a Minneapolis-based money market fund, which for years proudly advertised their record of superior performance. Their success was perplexing: Money market funds, with their strict guidelines for safe investment, generally lack the latitude to significantly outperform their competitors. The puzzle was solved when it was learned, following catastrophic losses, that the manager had hidden derivative investments. Market efficiency implies that investments that look too good to be true probably are.

In determining the relation between risk and required return, financial theory distinguishes between two different types of risk: diversifiable (or idiosyncratic) and market. The theory states that investors will be compensated for market risk, but not for diversifiable risk. Most investments have elements of both types of risk. Market risk arises from common factors, such as business cycle fluctuations, and affects almost all assets to varying degrees. Diversifiable risk is not correlated across assets, and, as its name suggests, it can be eliminated by diversification. It is the nature of diversifiable risks that when one asset has a higher than expected return, another is likely to have a lower than expected return. Thus those risks cancel out in a diversified portfolio. In contrast, market risk cannot be eliminated by diversification because it affects all assets simultaneously in the same direction.

Finance theory states that investors are compensated only for market risk, not for diversifiable risk. Market efficiency is a key ingredient to this conclusion. The idea is that astute investors recognize that some risks can be diversified, and hence accept these risks without extra compensation as part of a diversified portfolio. These diversified investors bid up the prices of assets with idiosyncratic risk until prices reflect only market risk. As a result, undiversified investors will find themselves bearing idiosyncratic risk without any compensation for it. This line of reasoning also makes clear the importance of diversification. In an efficient market diversification is essential to ensure investors returns commensurate with risk exposure.