Not by Return Alone: Judging Investment Performance

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This article is the second part of an article about the relationship between risk and return.  Part one can be found hereThis is intended for the educated layman. It was written as part of a continuing series of essays on a variety of investment topics.

Wherein we discover that the connection between return and risk is neither rigid nor obvious, and that we can be cheated of our money by disregarding risk and fixating only on return.

Return and risk are not lashed to each other

If you believe, rightly, that return and risk are related, you may be inclined to stride further down this path on the assumption that return is always proportional to risk, that higher risk implies higher return, and vice versa. Stop. This path will lead you into a swamp of bad investment decisions.

Return and risk are not lashed tightly together. All the mysteries of finance arise from the intricacies of their relationship.  Consider, for example, gold.  The price of gold has varied enormously since the U.S. came off the gold standard.  That is, its price, and therefore its returns, has been volatile.  But apart from the first decade after the dollar price was set free, in 1968, long-term returns to gold have been negligible. Moreover, there’s little economic reason to think that gold ought to produce a high return in the long run. It probably won’t. (That is, of course, unless all other assets have negative returns; that’s what makes gold a hedge against disaster.) Sure, it may produce a great return from time to time when, starting from a low price, it goes up to a high price, as it has recently. That follows ineluctably from the definition of volatility.  But it’s the return we expect in the long run that concerns us as we define the relationship between return and risk, not our ability to identify the troughs and crests of volatility.

This seeming violation of the common sense that higher return is associated with higher risk should not be written off merely as an idiosyncrasy of gold. There is a multitude of such investment idiosyncrasies.

Consider by analogy the maxim that you get what you pay for.  Consumer Reports has created a highly successful (not-for-profit) business built on the proposition that this is not strictly true, and it supports this with evidence.  I’m looking at a recent issue, which shows that you can pay $3300 for a refrigerator that is scored much lower than one of the same design that costs $1700. Quality is not directly related to price. Now, if you look across the entire range of kitchen appliances, for each type, the least expensive ones on the whole have lower ratings than the most expensive ones.  And there comes a point where no matter how much you’re willing to spend, you simply can’t get a better refrigerator, or oven, or dishwasher.