You Know The Drill: Risk vs. Return

Mark Wendell | Jan 21, 2015

By Mark Wendell

Nobody understands risk, it seems. History is replete with brilliant people who made calamitous investment mistakes. To paraphrase a comment by Warren Buffett about a Wall Street firm’s collapse and the risks they took: “To make money they didn’t have and didn’t need, they risked what they did have and did need”.

What is all the fuss about risk? It seems that everyone has an opinion about investment risk. What are we to think, what are we to believe, and what are we to do?

We take advantage of several time-tested strategies in our risk-managed investment portfolios, such as:

Holding for the long term
Diversifying broadly across many investment asset classes
Including multiple investment management styles and multiple managers investing in many countries
Building portfolios that are consistent with your age, financial considerations, personal goals, and tolerance to account value fluctuations
Rebalancing periodically, monitoring closely and making changes as needed, always with a view of your ever-changing personal situation and objectives

Let’s take a closer look at why risk-managed portfolios that use these types of strategies are important.

The Connection Between Risk and Reward

Why can’t investors ignore risk and focus only on the return of their investments? To answer this question, we need to understand the integral relationship between risk and reward. The greater the amount of risk that an investor is willing to take, the greater the potential return they expect. The reason for this is that investors would usually choose the less risky investment if they were not compensated for accepting the risk of an investment that has a higher chance of poor performance. In other words, if an investment is more likely to perform worse than another available choice, it also must be more likely to perform better than the alternative for rational investors to consider it for their portfolios.

To demonstrate this concept, we can compare U.S. Treasury bonds and corporate bonds. Corporate bonds usually provide a higher rate of return than U.S. Treasury bonds. However, a corporation is much more likely to go bankrupt than the U.S. government. Because the risk of investing in a corporate bond is higher than investing in a secure government bond, investors are offered a higher rate of return to compensate for the additional risk. The same principle applies to stocks: Investing in a well established, dividend-paying company usually has a lower risk of significant investment loss than investing in a small, unproven product company.

The Science of Investing

Thus far, we have discussed risk in terms of individual portfolio holdings. However, managing risk at the portfolio level can be a very effective way to mitigate the risks of individual holdings. Portfolio diversification includes choosing a variety of investment types or asset classes based on their expected returns, their correlation to other asset groups in a portfolio, and their anticipated valuation volatility, as measured by specific metrics. (Correlation means how likely it is that an investment or group of investments will move in tandem, either up or down, with another investment or group of investments.) Investing in multiple styles of management can add to this diversification. For example, sometimes the market may favor value-oriented managers, and at times growth may outperform, and at other times European bond managers may perform better in a specified period of time.

Rebalancing the portfolio is also related to risk management because if one asset class does particularly well, it will become a larger percentage of the portfolio than originally intended. It is important to periodically lock in these gains and rebalance back to the original allocations we established. As we rebalance, we can also consider taking advantage of opportunities for tax loss harvesting to offset gains as a strategy to improve our tax obligations.

Managing the Risk of Our Own Emotional Reactions

Investors may also attempt to quantify and list known and potential elements of the risks of an investment from our personal points of view. We can consider both this personal list and a long universe of other possible risks. Completing this exercise serves to maintain focus on factually based, real-world risks rather than our exaggerated, emotionally based, worst-fear fantasies.

But there is a big difference between what one believes their ability to withstand portfolio depreciation or sizeable movements up and down to be and what it actually is. When market stress hits a person’s bottom line, how do we feel and what do we do? Even if our risk tolerance is relatively high, our risk appetite may be much lower. Risk appetite is based on our personal fears, originating from personal experiences that color our perception of current reality. In contrast, risk tolerance is based on a projection into a hypothetical future point in time, and, as such, does not elicit the same level of emotional response.

There is a common tendency to get lulled into a false sense of security during booming markets and, conversely, to become overly cautious and pessimistic after prices have dropped. It is important that we understand that we should not invest more aggressively when markets are up and less so when the markets are down, as doing so is contrary to a successful investment strategy. Instead, the goal should be to create a portfolio that aligns with our underlying tolerance for risk, while at the same time being acutely aware of our true appetite for risk. Remember, there is a difference between our perception of our tolerance of future risk and our actual, in-the-moment appetite for risk.

As an antidote to emotional, self-destructive behavior, we want to employ a plan to permit a healthy investment portfolio to thrive in any market condition. As a first step in making this plan, below are questions that every investor should answer.

What is my reason for investing and why am I choosing this type of investment?
What is the eventual purpose intended for the funds invested?
How long can I keep the funds in the investment?
What do I expect to get from the investment over time, and what is the expected average annual return?
What percentage of my total net worth is my investment?
What are my personal monthly/annual income requirements and do I need to pay for regularly recurring expenses from my investment account? Is this amount realistic relative to the expected return on my investment funds?
Do I require a periodic payment from the investment and what percentage is this annual amount to the total investment? Do I expect the investment, in view of the periodic payout, to sustain itself without touching the principal, or how soon will it deplete?
How long do I expect the investment to last relative to my requirements, other assets owned, cash flow needs, and my expected lifespan? This relates back to the expected return. Am I aware of my lifespan longevity risk and my long-term anticipated spending needs?
Am I able to allow for, and pay for, objective professional management of my investments to optimize the probability of achieving my objective for investing?
Am I willing to participate in an exercise to quantify and define my personal risk expectations and tolerance parameters as well as define a risk budget allowance for the investments? This allows for a psychological risk self-assessment awareness to be achieved that would help predict my investment behavior in various market conditions.
Am I willing to be held accountable to the agreed upon risk profile budget for my investments, where risk is defined, for example, in terms of volatility and expected risk adjusted returns (the return obtained relative to the risks taken) as well as my ability to withstand losses, whether temporary or permanent? (Investment decisions are based upon history, knowing that future results may differ from actual past performance.)
Am I willing to openly participate in ongoing investment review discussions with professionals to evaluate my own behavior and feelings relative to my investment portfolio performance?
Am I willing to be educated and counseled on investment risks/returns/costs and compare my metrics and performance results to appropriate benchmarks? (i.e., the MSCI ACWI All Country World Index, which is more appropriate for well-diversified portfolios than a popular U.S.-only index such as the S&P 500 or for a diversified bond portfolio, the Barclays Agg index is commonly used).

You Know The Drill: Risk vs. Return