The Less Understood Relationship between Risk and Returns

Risk and Reward go hand in hand. Higher the risk, the higher the return. Isn’t that what most of us have come to believe?

Well, this understanding is only partially correct.

Why?

If you could earn a high rate of return simply by taking higher risk, a lottery ticket would be the best investment. And you would find the world’s best investors in casinos.

If we define risk as the loss of capital, you can lose your entire money quickly with a lottery. That makes it a bad investment, doesn’t it? However, there is another dynamic at play. When you lose, you lose only small amounts. But when you win, you win really big. That’s what attracts many people towards lotteries. What we ignore here are the odds of winning. How many people have become rich by buying lotteries? Moreover, when you lose small amounts many numbers of times, you still lose a big amount.

By the way, let’s not look down upon people who buy lotteries. Many investors tend to like investments with lottery-like characteristics. If you prefer to invest in penny stocks, you are essentially displaying a similar preference. Stocks become penny stocks for a reason. These are the stocks that are struggling severely operationally or financially. There is a good chance that these companies will never recover. Still, many investors invest in such stocks. And the investment psychology is no different from that of a lottery buyer. You invest Rs 10,000 in Rs 2 stock. If this stock goes to 50 (somehow), you make Rs 2,40,000. If the stock goes to zero, you lose only Rs 10,000.  Not much different from a lottery.

I copy the 1-month chart of Jet Airways (as on November 18, 2019). The company has ceased operations 3-6 months back. The stock is still trading. Why are people investing there?

Do note that there can be some amazing turnaround stories in some of these penny stocks. Smart value investors may be able to find great bargains. However, how many of those who invest in such stocks have time and more importantly the skill to figure that out? And traders work with an entirely different thought process.

Certain investments are RISKY for a reason

If we were guaranteed to earn HIGHER RETURN by taking HIGHER RISK, we wouldn’t call the investment RISKY, would we? We call an investment RISKY for a reason, don’t we? The risk is that you can lose money (or not earn the desired rate of return).

The one book that you must read about investment risk is “The Most Important Thing” By Howard Marks. No other book on investment I have read discusses “how to think about investment risk” in a better way. I copy these risk-return graphs from one of the memos (Risk, January 19, 2006) that Howard Marks sends out to his investors. The same graphs are reproduced in the book. You can access all the memos from Howards Marks on this link.

This is how most of us perceive the relationship between risk and returns.

However, the following is a more accurate description of the risk-reward relationship.

As you can see, as the risk increases, the excepted return increases (Along the straight line. Excepted return can be different from the actual return you experience). However, as the risk increases, the range of potential outcomes also increases. There will be many outcomes with better returns than expected (mean) returns and many outcomes with worse returns than the mean returns. As you can see in the graph, as the risk is growing on the X-axis, the probability of earning poor (or even negative returns) is also increasing.

The first graph (where the risk-reward relationship is a straight line) does not depict the uncertainty associated with risky investments. The second graph does.

I copy an excerpt from the memo from Howard Marks.

As an investor, what should you do?

With every investment you make, appreciate the risk involved. I am not saying that you must not make risky investments. At the same time, you must appreciate that you can experience a loss or lower than desired returns. Appreciate the uncertainty of outcomes in risky investments.

When you appreciate the uncertainty involved, you will automatically gravitate towards diversifying your portfolio, which is a good thing to do.

In my opinion, many retail investors lose money because they tend to under-appreciate the risk in investments during good times. For instance, in the years 2016 and 2017, I saw many portfolios that had only mid and small cap funds. These funds had done well over the preceding 2-3 years. Such investors must have thought that such super performance will continue (no element of uncertainty involved). They just didn’t think that mid and small cap stocks were risky and therein lies the problem.

By the way, the same set of investors can tend to over-appreciate during bad times and avoid risky investments.

We must also remember that even if your investment turned out to be successful, it does not mean that the investment was not risky. It was risky. There were many outcomes possible, both favourable and unfavourable. Just that the risk didn’t materialize for you and you got a favourable outcome. It is possible that you got the odds in your favour through skill and research. At the same time, you could have just been lucky. A bit of humility will help.

Just because you want to take more risk does not mean that the capital markets will reward you. I have come across investors, where it feels like something has dawned upon them. They never invested beyond the comfort of FDs and provident fund. Suddenly, they want to put their entire capital in equity markets. Recency bias. They believe the outperformance will continue. Or that the outperformance is guaranteed if they invest through SIPs. Such investors are unlikely to see merit in diversified portfolios. Such investors are setting themselves for investment disasters.

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This post is for education purpose alone and is NOT investment advice. This is not a recommendation to invest or NOT invest in any product. The securities, instruments, or indices quoted are for illustration only and are not recommendatory. My views may be biased, and I may choose not to focus on aspects that you consider important. Your financial goals may be different. You may have a different risk profile. You may be in a different life stage than I am in. Hence, you must NOT base your investment decisions based on my writings. There is no one-size-fits-all solution in investments. What may be a good investment for certain investors may NOT be good for others. And vice versa. Therefore, read and understand the product terms and conditions and consider your risk profile, requirements, and suitability before investing in any investment product or following an investment approach.