“There is risk, there is return, and there are costs. All else is marketing.”
This is part of a four-part series on investing basics. You can follow along with the entire series here:
-Part 1: Where do investment returns come from?
-Part 2: Investment risk and return
-Part 3: Determine your asset allocation
-Part 4: Implementing your investment plan
In last week’s post, we looked at the question of where investment returns actually come from. We looked at the research done on this topic and found that your returns are dictated by the market returns as a whole and your individual exposure to those markets, commonly known as your asset allocation. With those tenets in mind, we concluded that your personal investment strategy can essentially be determined as follows:
1. Determine the amount of market exposure you would like to have with your investments.
2. Obtain that market exposure by finding investments that mimic the markets as closely as possible.
3. Do this at the lowest possible cost.
Before you get into Step 1, which is essentially determining your asset allocation, I think it’s important to understand a little bit more about the nature of returns and where they come from, just so you know what you’re getting into ahead of time.
Today’s topic is on the relationship between risk and return and how it affects your investment decisions.
What is investment risk?
Risk can be defined in many different ways, and the reality is that it will mean many different things to many different people. But in the investment world, it’s primarily defined in one way: standard deviation.
Standard deviation is just a statistical measure, but with investing it’s used to measure the certainty of returns. An investment with a high standard deviation is one that has high level of uncertainty with regards to its return. A low standard deviation means there is more certainty. Standard deviation is often reported along with an investment’s expected return to give you some sense of what you can expect from that particular investment.
As a simple example of how this works, stocks have a higher expected return than bonds, but also a higher standard deviation. What this means for you is that while stocks offer the potential for greater long-term growth, they also carry a real risk that you will end up with much less money than you expected. This risk exists even over the long-term.
How is risk related to returns?
Very simply, if you want the possibility for higher returns, you have to accept a higher level of risk. If anyone is offering you a method to get higher returns for less risk, unless they’re talking about something simple like diversification, they’re selling you something that doesn’t exist.
Logically, the relationship between risk and return makes sense. Investors wouldn’t willingly take on more risk if there wasn’t some kind of compensation. And you can see this kind of thing happening in simple ways all of the time. A lower credit score indicates that you are a higher risk, and therefore you will receive a higher interest rate when you apply for something like a mortgage or credit card. The lender, who is essentially investing in you, is requiring a higher rate of return to be compensated for the additional risk they are taking on.
Not all risks are created equal
While it’s important to understand that the prospect of higher returns requires you to take on more risk, it’s just as important to understand that simply taking on more risk does not mean you should expect higher returns. There are some types of risk that compensate you with returns and some types that simply add risk without any compensation.Systematic risks, or market risks, are those that are characteristic of an entire market. With stocks, you have the risk of recession or even of the value going completely to 0. Bonds are highly sensitive to inflation and interest rates. These are the kinds of risks that are inherent in the markets themselves and cannot be removed, and therefore these are the risks for which investors are compensated.
On the other hand, unsystematic risks are those that exist only in specific parts of the market. As a simple example, a single company will be subject to many risks that the market as a whole is unaffected by. Their top people could leave. Customers could decide to use another product. Their building could be hit by a tornado. While these events would have a major impact on that company, the market as a whole would largely be unaffected. These kinds of risks that are specific to a given company, industry or country are generally not compensated because the investor could avoid them by simply investing in the market as a whole instead.
What risks are not really considered in the above?
The biggest risk not considered in all of the above is the risk of your personal reaction to market movements. If you as an investor are prone to sell every time there’s a big drop in the stock market, then stocks will carry an additional risk for you that is not accounted for in standard measures. That’s not to say that you shouldn’t own any stocks, just that you might want to consider a smaller allocation.
How do I use this information to make decisions?
Understanding your personal reaction to market movements is a key part of developing a strong investment plan. As a general rule of thumb, you should be comfortable with the possibility of losing 50% of what you have allocated to stocks within a given year. So if your portfolio is 70% stocks, you should understand up front that in any given year the value of your investments could fall by about 35%. This is a rough estimate that can help you think about how you might react to different market conditions and how that should affect some of your decisions.
Furthermore, understanding which risks compensate you with higher returns and which do not will help drive your decisions. Very simply, diversification is the tool that will allow you to avoid the risks that do not compensate. In practice, this simply means that you buy index funds representing entire markets, so that you do not have over-exposure to any individual company, industry, country, or other sector of the market that may contain unique risks without the corresponding higher returns.
If you can remember the quote at the top of this post, you will save yourself the trouble of being persuaded by “too good to be true” investment opportunities. There are no magic bullets with investing. You must take on additional risk if you want the possibility of additional returns. Beyond that, there are the costs you incur for investing, and as they say, the rest is pure marketing.