How to Think about Return and Risk at the Same Time

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This introductory article is intended for the educated layman. It was written as part of a continuing series of essays on a variety of investment topics.

 

My Worldview and Welcome to It

Introduction

 

Robert Benchley wrote, “There may be said to be two classes of people in the world; those who constantly divide the people of the world into two classes, and those who do not.” Someone from the former group has said that investment analysts can be divided into two classes: the academics and the sportsmen.1 The academics dispassionately systematize the processes of selecting stocks and bonds and putting them together into portfolios, and the sportsmen are caught up in the excitement of picking the stocks that will have great returns. If you’ve read my earlier articles, I needn’t tell you to which class I belong. That’s not to say anything against the sportsmen. The financial markets need both classes in order to function efficiently and to provide the greatest benefit to society.

The discourses of the academics trickle down to the public with hardly a trace.  For better or worse, the sportsmen, abetted by the daily financial press, mould the public perceptions of investing.

These perceptions sweep across a broad horizon, but two extreme and opposing views have been commonly held by the public: Does the market give you something for nothing? Or is it a casino?  Surely there are few who still maintain the first view, which was common during the febrile summer of the dotcoms in 1999, though it was seldom so starkly expressed. Since the market collapse of 2008, far more have adopted the gambling metaphor.

The truth is not midway between the extremes.  In investing, you can never get something for nothing.  Investing can, however, come close to resembling a casino, but only if you choose to make it so.

In order to understand why investing is at neither of these extremes but at some intermediate point of your choosing, one must grasp the relationship between return and risk. Return and risk are essentially paired, not like Gilbert and Sullivan, Minneapolis and St. Paul, or even love and marriage, but in a much deeper, inextricable way, like energy and mass.  This is because both, fundamentally, concern the same things: value, and changes in value.

What we get from an investment, the prospect of an increase in our wealth, comes at a price: the prospect of risk of loss of value. If you want return with no risk, the only choices are cash or an investment in U.S. government inflation-indexed securities,2 and even with these, you’ll lose money after the payment of taxes.  All other investments require that you assume some risk. There are times when the stock market continually rises, but that does not mean that it lacks risk, even temporarily.

This article will explore the relationship between return and risk, concepts that we tried to consider separately in my two previous articles (which, for brevity, I will refer to as “Essay on Return” and “Essay on Risk”).  Even there, it wasn’t entirely possible to isolate the concept of risk from the concept of return.  As I wrote before, the definition of risk most pertinent to the individual investor is the possibility of falling short of the amount of wealth needed or desired.  But I pointed out the practical limitations of this definition, and I proceeded with the alternative definition of risk as the volatility (or variability) of return, with all its slippery uncertainties and ambiguities.  In this article, we’ll continue with the latter definition and come back to the idea of shortfall risk in a future article on risk tolerance.

At the level of late-night undergraduate philosophizing, “there is an appealing and psychologically comprehensible sort of metaphysical pathos in the idea”3 that we live in a slowly expanding universe of financial rewards and risk, where risk is in flux and can be shifted but never destroyed. Be this as it may, it’s not contrary to reason, and there’s no evidence against it. An appreciation of this worldview may help you to see through the eyes of those of us financial professionals who call ourselves “quants,” that is, the academics (as distinct from the sportsmen.)  Leaving this to one side, a grasp of finance requires that one appreciate first, that return is inseparable from risk, and second, that broadly speaking, the prospect of larger returns implies the prospect of larger risks. That bald statement, however, does not capture the complexities and nuances of the relationship.

Over the last half century, and until the current economic crisis, the world of the real economy experienced a steady decline in risk, as recessions proved to be shorter and milder than earlier in economic history.  This has been named “the Great Moderation.” At the same time, the world of financial instruments became more volatile, with more violent crises, like the stock market crash of October 1987 and the Asian financial crises of 1997.  In the view of some, this reflected a transfer of risk from the real economy to the financial markets, and for citizens living off their labor rather their investments this was a good thing.  Others have seen the increased risk of the financial markets as the consequence of the perversion of financial engineering and as a threat to the real economy. My own view is in between, but inclined to the latter.  I also think that it is too soon to say that the Great Moderation was not real, and merely a fortuitous and illusory decline in risk. (I’m an historian, not a journalist.)  But I won’t detain you any longer from our appointed subject.

Only when you can keep in mind at one and the same time the two concepts, return and risk, can you properly understand how to invest.  And you will also understand why you should invest.  Without the marriage of the concepts, you will be playing the market—or shunning it—as if it were a casino.


1 This implies nothing about the person’s academic attainments. The portfolio manager who first told me this defined himself as a sportsman and had a doctorate in comparative literature from Harvard.
2 Treasury Inflation-Indexed Securities, more commonly known as Treasury Inflation-Protected Securities (TIPS).
3 A. O. Lovejoy, The Revolt Against Dualism (London: George Allen & Unwin, 1930), p. 166. Lovejoy is actually describing the appeal of a worldview in which there is unity in everything being related to everything else through divine law.