Where returns and risks come fromThe first set of constraints: the nature of markets

The return an investor actually receives can be split into five terms: the time compensation earned by waiting, the risk compensation earned by bearing risk, the information advantage gained by knowing more than others, the costs paid when trading, and luck. All of this rests on the premise that promises are kept. Part One takes the equation apart term by term: where each term comes from, what it means for the market as a whole, and what risks come with it.

One equation

Realized return ＝ time compensation ＋ risk compensation ＋ information advantage － trading costs ＋ luckPremise: promises kept

Each term in the equation has a return side and a risk side, and the terms differ in what they mean for the market as a whole. Time compensation and risk compensation are available to everyone; information advantage is zero-sum; trading costs are negative-sum; luck averages out to zero over the long run.

The decomposition of returns and the structure of Part One

Each column is one term of the equation: above, its return and its risk; below, the chapters that derive it. Tap a term for an explanation; finished chapters can be clicked to open.

ReturnInterest

RiskInflation, maturity mismatch

Section One2Interest rates and maturity

ReturnRisk premium, factors

RiskVolatility, drawdowns, fat tails

Section Two3What risk looks like 4Diversification 5Compounding and volatility drag 6Factors

ReturnExcess return

RiskAdverse selection, false confidence in being informed

Section Three7Why prices are hard to predict 8How information gets into prices 9Traders in the market

ReturnNone

RiskLiquidity, execution

Section Four10Liquidity and the bid-ask spread 11Orders, rules and market structure

ReturnShort-term results

RiskDispersion of outcomes

Section Five12The arithmetic of active management

RiskCounterparty risk, institutional risk

Section Six13How promises are kept 14Why regulation exists

Tap a term in the equation.

Chapter 1, "What financial products sell", is the opening and explains what returns are returns on.

How to read this part

Chapter 1 is the opening. It explains what returns are returns on: a financial product delivers a promise. The six sections that follow each correspond to one term of the equation. This part assumes no background in finance and no mathematics; each chapter starts from a concrete phenomenon and uses economic analysis to examine the participants' motives, constraints and outcomes.

Summary of Part One

Once the return equation is taken apart, the conclusion fits in one sentence: what ordinary investors can reliably earn is time compensation and compensation for systematic risk; information advantage is steadily used up by competition, trading costs must be paid, and short-term results come mostly from luck; and all of this depends on promises being kept.

Summary of Part One: what each term of the equation yields

Switch views: each term's conclusion, its implications for financial products, and its implications for AI entering financial products.

Each row corresponds to one section of Part One; chapter numbers are shown beneath each term.

These conclusions form the first set of constraints on designing financial products. The second set comes from users: what people need to accomplish, what they can bear, and what makes them trust. The third set comes from AI: how much an agent can reliably do on people's behalf.