Trade-off: Risk and Return

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Trade-off: Risk and Return

Investors typically focus on returns. ‘How much money am I making’ ‘How much money did I lose’ ‘Am I getting better returns than the S&P/ my neighbor/ the guy on TV’.
 
All of those are relevant questions, but without a consideration of the risk involved, the answers themselves are meaningless.
 
To incorporate the concept of risk into returns, investors are taught that in order to generate higher returns, they need to take higher risk. This concept is demonstrated by typical asset class returns historically- the safest and lowest risk investments (cash and government bonds) historically generate the lowest returns, whilst some of the highest returns come from much more volatile, higher risk investment propositions such as private equity and small cap stocks. This is demonstrated visually by the well-known ‘capital market line’:
This simple representation does at least incorporate risk into the assessment of return. However, it is also very misleading. This chart teaches investors that by taking more risk, they will receive a higher return. By this logic, as investors we should all take as much risk as possible as we will be rewarded for it in higher returns. This clearly misses the most important element of risk- the uncertainty that comes with any given return. For the further you travel to the right along that line (taking on more risk) the greater the uncertainty and variability of those returns. That is an important point for two reasons:
  1. The consideration of the higher level of uncertainty in return is important at the outset in forming one’s investment strategy.
  2. The consideration of the risk level taken to achieve a given return historically is vital when assessing performance of any investor or strategy.
Let’s address each of those two in order.
 
1. The consideration of risk in terms of return uncertainty when forming an investment strategy
The best way to consider the uncertainty that comes with taking greater risks (either at a portfolio or individual stock level) is by reminding ourselves that the Capital Market line in fact just shows an average of returns, rather than displaying the potential range of returns. Herein lies its major fault, and the reason it is so misleading. The following is a much more helpful version of the chart:
You can see that while increasing your risk level should technically increase your return, it also crucially increases your variability of return, or your uncertainty. For some clients, whilst they might want the returns commensurate with small cap stocks, they cannot cope with the level of uncertainty or the range of potential returns which that might entail. This is a crucial point- just increasing your risk level does not mean that you will receive a higher return, it only means you have the potential to receive a higher return, and of course also the potential that you might receive a lower return also. For many clients this downside risk of capital loss is greater than the risk of missing out on a few percentage points of return on the upside.
 
2. The consideration of risk when assessing historic returns
Suppose two investors achieved a return of 5% in a year, but A did so with a risk score of 5, and B with a risk score of 8 (see below). (There are various ways to measure this ‘risk score’, the most common is volatility- however for this example the numbers themselves are somewhat arbitrary).
In that year, by assessing the two investors simply on their returns, you would determine they were equally skilled, having both returned 5%. However, investor A has in fact demonstrated significantly more investment skill- managing to generate the same level of return with much less risk. As a result, had the market environment been different he would likely have performed much better than B. The problem is that the level of risk is very difficult to measure and often goes unnoticed by many investors, particularly in years such as this when the risk level has not impacted returns. Put another way, if one investor can generate the same return as the S&P, but do so with far less risk, whilst his returns do not appear any better, he is in fact skillful and adding value- value that will become very apparent in market downturns. Investors do not typically make the front page of the paper for such results, they do not receive awards or plaudits. Those are saved for the investors who generate the highest returns, yet they are often also those investors who suffer most during difficult market periods. Remember the first rule of investing is ‘don’t lose money’. And the second rule of investing is ‘don’t forget rule 1’ (credit Warren Buffett).
 
The problem we have is that risk is only an issue and often only really becomes obvious when things go wrong. In good years such as the one above, it is not an issue and people become complacent about it. “It’s only when the tide goes out that you see who’s swimming naked” (credit Warren Buffett, again).
 
Not only is risk difficult to quantify, sometimes certain risks may be entirely legitimate yet never materialize, and investors may be wary of and position for things that may never come to pass. Does that make them wrong? Or overly prudent? Did a manager position for a risk that was likely, but in fact did not occur? Is this a lack of skill or a reflection of the fact that short term outcomes are dependent on many random and unknowable factors? To try to answer these questions is difficult, as many risks are subjective, not quantifiable and therefore not measurable.
 
Regardless of the inherent difficulty in measuring risk, it is clear that to truly assess any investment performance, we must consider the risk budget expended in achieving that return, be that on an absolute level (in terms of potential capital loss) or on a relative level (in comparison to other investors, or an index).
 
Conclusion
  • Investors should never consider return without also considering risk.
  • Investors cannot expect a greater return simply for taking additional risk.
  • Whilst difficult to measure (particularly in good times) risk will become very apparent after the event. As such, it needs to be considered at all times, bad and good.

Disclosures: This blog expresses the views of the author as of the date indicated and such views are subject to change without notice. Globescan Capital, Inc. has no duty or obligation to update the information contained herein. Further, Globescan Capital, Inc. makes no representation, and it should not be assumed, that past investment performance is an indication of future results. Moreover, any information or opinions contained in this blog are not intended to constitute a specific recommendation to make an investment.

The information contained herein does not constitute and should not be construed as an offering of advisory services or an offer to sell or solicitation to buy any securities or related financial instruments in any jurisdiction. Certain information contained herein or linked to is based on or derived from information provided by independent third-party sources. Globescan Capital, Inc. believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based.

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