How Risk and Return are Related
The very high cost of emotions
Many people have a negative emotional reaction when they hear the word "risk".
Generally we equate the word "risk" with the fear of loss. People are afraid to lose all or some of their money. Perhaps they will not have enough to live on or to do the things they want.
It is important to understand the meaning and significance of the term "risk" as it is used in the Financial Planning industry.
A failure to understand this issue can have a devastating effect on your finances.
Here is a simple example of how a "safe" investment of $25,000 would have made you $230,000 less than a so called riskier investment.
From 1985 to 2008 cash (Cash Management Trusts) returned an average of 4.7% after inflation. Australian shares returned an average of 10.6% after inflation.
If you had invested $25,000 for 25 years:
- your "safer" cash at 4.7% would have become $79,000
- your more "risky" Australian shares would have become $310,000.
Simply reading on might help you avoid becoming one of those people who retires with hundreds of thousands less than they should.
What does "risk" mean in investing?
We are not using the word "risk" in the context of making some stupid investment with conmen, crooks or people who offer returns highly in excess of the market. Clearly these are things you should never do under any circumstances.
When Financial Planners talk about "Risk" they are usually talking about the degree of uncertainty.
There are many studies that show:
- investments with the least uncertainty (safer) have lower average returns
- investments with more uncertainty (risk) have higher average returns.
Whenever we use or you hear the word "risk" in this context you should substitute it with the word "uncertainty" to have a better understanding.
Below are a three links that provide further information. I enjoyed reading them but my wife thought they were a bit too heavy duty - you have been warned!
Harry Markowitz won the 1990 Nobel Prize in Economics for explaining the relationship of risk and return in his theory of portfolio selection, also known as modern portfolio theory.
A good but quite technical explanation of risk is the article "Defining Risk"
Some risks or sources of uncertainty can be reduced through diversification.
However just as the misunderstanding of the term "Risk" has actually created losses for many investors, so too has misunderstanding around "diversification".
Examples of more and less risky investment
A few examples below show the risk / reward ratio starting with the least risky first. The examples are based on investing in Australia.
Australian banks and Australia itself would be considered less risky than many other countries.
- Cash in a bank safe deposit box might be considered risk free (at least safer than under your mattress). It will not earn any interest, will not keep up with inflation and of course the bank could burn down, get robbed or the notes eaten by pests - nothing could be considered 100% risk free.
- Short term government bonds (known as treasury notes) which pay the "risk free rate". The chances of the Australian Government defaulting on their short term obligations are remote.
- As a general rule, cash management trusts and term deposits are very smooth and predictable. They don't pay much more than the risk free rate.
- Bonds that are issued by safe companies and not too unsafe governments pay more interest but sometimes such a bond can lose most or all of its value.
- Then you have shares and property each with multiple categories of their own.
Long term reward of shares versus bonds
Shares can go up and down by a lot. One extreme case was when the whole stock market lost 25% on the 19th October 1987 - in just one day!
However, overall over the last 120 years, shares have returned 6-7% more each year than the "risk free rate".
Do not underestimate what 6% means in actual dollars in your pocket. I have explained that in more detail on the page The Power of Percentages.
The trouble with shares is that the average investor earns much less from shares than the share market as a whole. There is a famous study from Dalbar, Inc that shows that the average US share investor in the 20 years from 1986 - 2005 earned 3.9% a year while the whole share market went up by 11.9% a year.
An investor who invested $25,000 in an index fund in 1985, 20 years later would have had $416,000 (ignoring tax and transaction fees).
The average investor who started out in 1985 with $25,000 over the same time period would have ended up with $65,000, barely beating inflation.
The reason for the difference is inappropriate buying and selling.
Is there a right level of risk?
Risk (uncertainty) is not good or bad in itself.
Each investor is different and has different needs and requirements.
How much risk is right for an individual might depend on circumstances such as:
- job security
- family commitments
- financial literacy
The more uncertainty (up to a point) an investor can accept, the higher the average return the investor can expect.
Most people can't handle downward uncertainty - they sell when their investments get cheaper and they have taken a loss.
Many people can't handle upward uncertainty - their investment has done well or very well and now they sell for fear of things getting worse.
Neither strategy in the long run beats a simple buy-and-hold strategy.
Is there a wrong level of risk?
Gambling is all about losing money
Some so called investments are really gambling.
Most people would consider betting on races to be a gamble. They would also consider playing at casinos and pokies to be gambling.
Most people would not consider their "investments" in property, shares and even bonds to be gambling.
Example of gambles masquerading as investments and of gamblers include:
- where transaction costs are greater than 3% a year,
- most day traders, buyers of contracts for difference (CFDs) and unsophisticated buyers of derivatives,
- anybody who does not have specialist knowledge and incurs a lot of transactions.
In the above examples if the investor / gambler has no specialist knowledge then the transaction and taxation costs will eat up any gain and much more over time.
A very small number of people are successful at day trading, derivatives, even horse racing. For these people, though, it is usually a full time job and they are in a small minority of all traders.
Mispriced risk is also a trap
Mispriced risk is where the investor does not get adequate compensation for the risk that they take.
One famous example is terrorism insurance. Until September 11th, 2001 it was very cheap, far too cheap to compensate for the World Trade Centre damage.
Another well known example of mispriced risk is Westpoint. Anybody who gave their money to Westpoint was fooled and not compensated for the risk they took. If they had read the information that was available to them at the time of investing they would have realised that there was a huge risk. Gambling in Westpoint provided no ownership of anything of value and you only got your money back if there was a real estate boom. The reward for this huge risk was only a few percent more than a term deposit.
A brief note about direct property investment
My wife and I have personally purchased 30 investment properties and been featured on the ABC TV program Inside Business in relation to our successful property investments. However, these articles will not cover direct property investments because it is a very hands on investment too often depending on the judgement and skills of the individual investor. It can not be quantified statistically in the same way as the share or bond market.
Please note that our success in property investment is not intended to suggest that a client would have a similar experience. I am not in any way endorsing (or not endorsing) direct property investment. Direct property investment is something that depends on your circumstances, the market at the time and the alternatives available.
It is very important to understand The Power of Percentages.
A 40 year old has an investment horizon of more than 40 years. Investments do not stop when you retire - your invested money continues to work.
If that 40 year old loses (or does not gain) an extra 3% a year, they lose half their investments by the time they are 63 - instead of $2 million the investor has under one million and it gets worse as they get older.
Providing clear and up-front financial knowledge -
so that you are truly served by being completely informed.