Understanding investment risk

Posted on Posted in Financial Blog

What is risk?

All of us take risks. Here in Los Angeles, for example, most of us ride in cars. We know that cars are risky, but we do it because we need to. But did you know that the average annual risk of dying in a car crash is 1 in 11,000? The risk of injury is nearly 34 times higher, 1 in 339. This means that after 75 years of riding in cars, you have nearly a 1 in 4 chance of significant injury. I’m not trying to scare you out of driving, just point out that we willingly take risks regularly.

We also take risks when we invest money, though these risks don’t include injury or death. Losing money can have significant consequences, but at least we haven’t broken any bones. Let’s take a closer look at financial risk and perhaps learn to feel as comfortable with it as we do in our cars.

In finance, risk refers to the uncertainty of the future value of an investment. This means that an investment like a bank CD, which has a guaranteed return, is virtually riskless because there’s no uncertainty as to what it will be worth in the future. Invest $1,000; get back $1,007 in 1 year, guaranteed (whoopee!). A stock, on the other hand, can go up or down over time; we can’t accurately predict what it will be worth in the future. That’s why stocks are considered “risky” investments.

All investments have risk. The benchmark “riskless” investment is a 3-month US Treasury bill, which is considered free of risk because your return is guaranteed by the US government, and the term is short enough so that inflation and interest rate changes have little effect. Every other investment has more risk, and this risk can be measured.

Measuring financial risk

In finance, we measure risk by the variation over time in an investment’s value, whether up or down. An investment whose value varies little, or is highly predictable, is considered low risk. An example would be a bond issued by the US government or a blue chip corporation. The return on these is stated as a rate of interest (for example, 2% per year), and the chances of not receiving this interest on time are extremely low.

A high-risk investment is unpredictable because its value can vary substantially. An example is the common stock of a young technology company (think Facebook). Because such a company has the potential to grow rapidly and become the next Google (or so we hope), as well as the potential to go bankrupt, the value of its stock can vary wildly from day to day. Over time, it might go up 10 times, or may fall 95% as the company’s fortunes sour.

A key characteristic of a very risky investment is that while its future value is highly uncertain, there is a chance for substantial reward. This is true of all risky investments: they can go up a lot as well as down. Finance theorists don’t distinguish between movements up or down, calling both of them “variation”: investments with greater variation in value over time are riskier.

As investors, however, we tend to focus on the down movements. In fact, we hate losses 2.5 times more than we like gains. This is why professionals talk about “downside risk,” or the amount of potential loss from an investment. But the key here is that loss and gain are closely linked: riskier investments have the potential for greater gain. In other words, you are paid to assume risk.

Risk and return

This is such an important concept that I’m going to explore it in more detail. To compare risk and return, we’re going to talk about asset classes, or groups of investments that share certain characteristics. The main asset classes are:

Stocks (or “equities”): shares representing partial ownership of a business

Bonds: debts of governments and corporations

Cash: very short-term bonds, such as money market accounts

Real estate: land and buildings

Everything else: precious metals, commodities, collectibles, and other “alternative investments.” We’re not going to talk about these here.

Let’s define another important term: return. The return on an investment is how much more than your cost you receive in the future, expressed as a percentage of the investment’s starting value. For example, if you invest $1,000 today and sell that investment for $1,100, your return was $100, or 10%. We typically express returns as an annual percentage, so if it took 2 years to return $100, then the annual return on that $1,000 investment would be about $50, or 5% per year. Obviously, all other things equal, we prefer higher returns.

We’re going to look at the historical returns of the 4 major asset classes defined above, and compare their return with their risk. What I aim to prove is that, over time, riskier assets produce higher returns. In other words, you are paid to assume risk. But first, I need to introduce one more concept: inflation.

Measuring purchasing power

Inflation is what happens when your money loses purchasing power. Over time, all currencies tend to lose value, so that the same good or service costs more than it did in years past. It’s crucial to include inflation in your return calculations because the total number of dollars that you have means nothing if they can’t buy anything. As an extreme example, look at Germany in the 1920’s. By the end of the decade, a pack of gum cost over DM 1 billion (Deutsche marks). That’s right, billion with a “b.” Inflation had been so severe during that decade that people carried wheelbarrows full of money to buy groceries. So in 1929 Germany, you could be a billionaire and still be poor.

Fortunately, inflation in the US has never been this severe, but it has nonetheless eroded the value of your dollar over time. Over the past 40 years, US inflation has averaged 4.2% annually, so that a dollar in 1973 is worth only $0.19 today. If you had invested $10,000 in an investment in 1973 that returned 4.2% per year, you’d have $51,845 by 2013. Unfortunately, that $51,845 doesn’t buy any more today than $10,000 did in 1973. So after inflation, you’d be no better off financially 40 years later. (At least you’d be no worse off, either. If you’d put the $10,000 in your mattress in 1973, today it would only buy $1,930 worth of goods.) In sum, inflation causes money to lose value. Always include inflation when evaluating investment returns.

Historical asset returns

Now let’s look at the return on $10,000 from different investments since 1973 (40 years), after inflation. Note that these “asset classes” don’t represent an investment in a single stock, bond or piece or real estate. Rather, they include all investments within that class of assets: all US stocks, all US bonds, etc. assembled into a diversified portfolio. Remember, because we’ve adjusted for inflation, you can buy just as much with each dollar in today as you could in 1973. Also note that the “final value” amounts below include your original $10,000.

[Note: I confined my illustration to the US here because the data are easier to obtain. The same conclusion would be reached if I included other countries.]

Return on $10,000 (since 1973) after inflation for different asset classes:

Cash in your mattress: -4.2% per year (Final value of $10,000 = $1,930)

Money market funds: +0.85% per year (Final value = $14,029)

US Bonds (10-year US governments): +3.2% per year (Final value = $35,378)

US Stocks (S&P 500): +6.0% per year (Final value = $102,252)

The investments are arranged from lowest to highest risk. Not coincidentally, their returns also go from lowest to highest. This is because the rational investor demands a higher return for taking on greater risk. As with return, risk can be quantified, but the math is much more complex.

Getting paid for risk

The graph below uses 75 years of real data to show that riskier asset classes do indeed provide higher returns over time, and that there is a linear relationship between risk and return. The red square in the middle represents large US stocks, while the green triangle at the upper right is for small US stocks. As you might expect, small stocks are riskier than large ones, and one is paid to assume that extra risk with a higher return.

The investments clustered in the lower left include US government bonds, US corporate bonds, US Treasury bills, and US inflation (which has the same “return” as cash in your mattress). Note that the last of these is the least risky investment of all, because its return is always known (a dollar is a dollar). But it’s also the worst investment, because you are guaranteed to lose purchasing power, which is what you should really care about (anyone want a billion 1929 Deutsche marks?). Moral: don’t keep cash in your mattress; invest it somewhere.

If you’re interested in learning more about the analysis of risk and return, please contact us.

Source: Campbell R. Harvey, Historical Behavior of Asset Returns, 2001.
Source: Campbell R. Harvey, Historical Behavior of Asset Returns, 2001.

 

Reducing risk

Humans are risk averse, which means that we try to reduce our risks. If we weren’t risk averse, no one would buy insurance or wear seatbelts. As investors, we prefer less risk for a given amount of return (or conversely, more return for a given amount of risk). Ideally, we’d like to reduce our risk without reducing our return. You might think from the above discussion that there’s no way to do this: to get more return you must take on more risk.

But there is a way to reduce risk without sacrificing return: it’s called diversification. To diversify, you combine different risky assets together into a portfolio. If you combine assets that do not perfectly correlate with each other (correlation measures how the assets’ values move in relation to each other), then your portfolio has lower risk than the individual assets. This is the basic conclusion of Modern Portfolio Theory, developed by Harry Markowitz way back in 1952.

For example, consider two stocks with roughly equal expected returns. If you own just one of these stocks, you are exposed to all of its risk. If the two stocks’ prices move exactly in tandem (i.e., they are 100% correlated), then owning both of them does nothing to reduce your risk. However, if the two stocks’ prices don’t move in tandem (they are less than 100% correlated), or even better, move in different directions (they are negatively correlated), then owning both stocks reduces the risk to your portfolio without reducing your return. That’s why one should own a portfolio with a meaningful number of stocks (typically, at least 50) in order to reduce risk without necessarily reducing return.

What works within an asset class (stocks in the above example) also works between asset classes. Thus, a portfolio combining both stocks and bonds, for example, is less risky, at any given level of expected return, than one containing just stocks or just bonds. Diversification obviously doesn’t eliminate risk, but combining different assets does mean that you are taking on less risk for a given return.

The graph below shows this, using various mixes of just stocks and bonds (the return numbers are different from mine because they are before inflation and the time period is different and excludes the 2007-2009 bear market). Note that a portfolio of 60% stocks and 40% bonds has an expected return of about 12%, only 15% less than the 14% expected return of an all-stock portfolio. At the same time, its risk is about 11%, 65% less than the risk of an all-stock portfolio. By combining these assets, risk falls faster than return.

Note also that a portfolio of 100% bonds is actually riskier than one with 95% bonds and 5% stocks, despite having a lower expected return. In this case, diversification really does offer a free lunch! For those who are truly risk averse, adding a small amount of stocks to a bond portfolio dramatically raises expected return with little or no increase in risk. From the graph below, you can see that adding 26% stocks to a portfolio of bonds increases the expected return from about 8.6% to 10.1%, while only raising the risk from 6.3% to 7.0%.

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This is the magic of diversification: you can reduce risk with little or no reduction in return, or choose to increase return with little or no increase in risk. There are infinite possible combinations: given the risk and return of different assets, plus their correlations, you can construct a series of optimal portfolios with the best risk-return trade-offs at any given risk or return target level.

Understanding this may be tough; accomplishing it is even more difficult. For this reason, many people hire a professional investment manager to construct a portfolio for their specific needs. Everyone’s optimal portfolio is different, and must balance the level of risk you are willing and able to take with the amount of return you need to reach your goals. At KCS, we specialize in helping clients develop a personalized portfolio as part of their personal financial plan, and then implement and manage that portfolio. If you want to learn more about how we do this, feel free to call or email.