More Risk, More Return?

In my last blog post, I wrote about how although investors spend a lot of time and energy trying to pick the best investments, the most important aspect of saving for retirement is the amount saved. Although the rate of return is certainly important and those saving for retirement would be wise to think about the long-term rate of return, the most important factor is the savings rate. When investors focus too much on earning a high rate of return, usually bad things happen as riskier and riskier investments are sought out. Traditional financial theory states that there is a direct link between risk and return, i.e. in order to earn a higher return, one must make riskier investments. And while this is generally true, especially when explaining the past, it is a mistake to assume that investors can simply dial up the risk of their portfolio and sit back and enjoy higher returns.

This is not the case for a couple of reasons. First, calculating the future risk of an investment with precision is impossible. Academics typically measure the risk of various investments based on how much the price of a particular asset jumped around in the past. Using historical data allows for a precise calculation, yet the precision with which a number can be calculated using historical data tells very little about what will happen in the future. Just because something can be calculated doesn’t mean it is useful. So even if an investor wanted to align his portfolio with a given level of risk, this is not something that can be done with precision. Second, if higher risk investments (again, typically measured as the historical volatility of returns) always provided higher returns, then they would fail to be high risk investments. If an investment guarantees a certain return, then by definition it can’t be high risk. Well-known investor Howard Marks has made some important points about the relationship between risk and return. The following slide is from a presentation given by Mr. Marks titled The Truth about Investing and graphically presents the way people typically think about risk and return.

Mr. Marks makes the key point: “But if risky investments could be counted on to produce high returns, they wouldn’t be risky.” Certainly an investment with high risk must offer the prospect of a high return in order to attract capital, but that return is far from a sure thing. The next slide is a graphical representation which does a much better job of characterizing the risk and return relationship.

This graph paints a great picture because it shows how higher levels of risk do not guarantee higher or lower returns, but rather a greater range of possible outcomes. In other words, as one takes more risk the possibility of return rises, but so does the possibility of a negative outcome. It is also important to note that as risk increases on the X-axis, the possibility rises of suffering an outright loss. Of course risk can’t and shouldn’t be avoided at all costs. If you seek to eliminate all risk on your portfolio, then you might earn a risk-free rate of return, which at the present time is pretty close to zero. Some risk must be accepted in order to have a chance of growing your portfolio and achieving your financial goals. Yet this must be done in a rational and informed way. And the temptation to ratchet up risk after a period of strong returns in the markets or as a way to supplement a low savings rate must be resisted. Periods of strong performance can cause investors to dismiss risk just like periods of bad performance can lead to extreme risk avoidance. Getting back to the original point, the less dependent you are on earning a high rate of return in order to achieve your savings goals, the more likely you are to achieve them and the less risk you must take. And if you happen to save too much, then at the end of the day you are left with a larger nest egg than you planned for. Surely there could be worse outcomes.