Risk and return: what you are actually being offered

For the members of the Financial Market Club, FSJES

In financial theory, expected return and risk are inextricably linked. An investor receives an expected return above the risk-free rate not as an entitlement, but as an explicit economic compensation for absorbing the risk of adverse outcomes.

Understanding this compensation mechanism clarifies what an investor can legitimately expect from Moroccan capital markets.

The risk-free rate and the Equity Risk Premium#

The foundation of modern valuation (from the Capital Asset Pricing Model of William Sharpe to discounted cash flow models) is the risk-free rate ($R_f$).

In the Moroccan financial system, the risk-free rate is defined as the yield on sovereign Treasury bonds issued by the Kingdom of Morocco, typically the 10-year Bons du Tresor (BDT 10 ans). Because the Moroccan state possesses taxing authority and the backing of Bank Al-Maghrib, default risk on domestic dirham-denominated debt is practically negligible.

Any investment in Moroccan equities must offer an expected return higher than the 10-year Treasury rate to justify exposing capital to business and market fluctuations. This additional spread is the Equity Risk Premium (Prime de Risque Marche - PRM):

$$\text{Expected Equity Return} = R_f + \text{Equity Risk Premium}$$

Moroccan financial research houses (such as Attijari Global Research, BMCE Capital Research, and CDG Capital) regularly estimate the Moroccan market risk premium between 5.5% and 7.0%. If the 10-year Treasury yields 3.5%, Moroccan equities must offer an expected annual return of 9.0% to 10.5% (combining dividends and earnings growth) to remain rational investments.

The Sharpe ratio: assessing reward per unit of risk#

Evaluating an investment purely by raw return is deceptive: a high return may simply reflect reckless leverage or extreme risk taking.

To evaluate genuine performance, financial analysts use the Sharpe ratio, measuring excess return generated per unit of total volatility:

$$\text{Sharpe Ratio} = \frac{R_p - R_f}{\sigma_p}$$

Where:

  • $R_p$ is the portfolio return.
  • $R_f$ is the risk-free benchmark (Moroccan Treasury yield).
  • $\sigma_p$ is the annual standard deviation of portfolio returns.

Consider two Moroccan equity mutual funds (OPCVM Actions):

  • Fund A: Generates 12% annual return with 18% volatility when $R_f = 3%$. Sharpe ratio = $(12 - 3) / 18 = 0.50$.
  • Fund B: Generates 9% annual return with 10% volatility when $R_f = 3%$. Sharpe ratio = $(9 - 3) / 10 = 0.60$.

Fund B generates a superior risk-adjusted return. It achieved its gains with far less turbulence, exposing investors to substantially lower drawdown risk.

The survival constraint#

Expected return is an average across hypothetical scenarios. In reality, an investor lives through a single historical path.

If an aggressive portfolio suffers a 50% loss during a market panic, it requires a 100% gain just to return to even. If an investor is forced to liquidate during that drawdown to meet personal obligations, the theoretical multi-year expected return is irrelevant. Capital survival is the binding constraint that governs whether an investor survives long enough to collect the market risk premium.

For discussion#

  1. If Moroccan 10-year Treasury yields drop from 4.0% to 2.8%, how does this shift affect the required rate of return and valuation multiples for listed equities on the Bourse de Casablanca?
  2. An investment salesperson claims that a 12% annual return in dirhams is promised with zero risk of loss. Using the risk-return principle, explain why returns are never riskless and why this claim misrepresents the underlying risk.
  3. Why do Moroccan mutual funds (OPCVM) benchmark their performance against the MASI index rather than simple cash deposits?

For the members of the Financial Market Club, FSJES.

Sources: Sharpe, "Mutual fund performance", Journal of Business. Bodie, Kane, and Marcus, Investments, chapter 6 (risk aversion and capital allocation). Attijari Global Research, Notes strategiques sur la prime de risque marche. AMMC OPCVM statistical bulletins.