RISK AND RETURN

What investors must understand about risk and reward

When it comes to investing your money, have the following thoughts ever come to your mind: "I want high returns but at low risk" or "I want to get 30% annualized returns, but must keep my principal safe". If so, then you are setting yourself up for disappointment.

Don’t blame the financial markets or your luck or your investment advisor. Rather take some time to understand that earning a high return at low risk is incompatible. If you want to create wealth for yourself and your family, you need to take some calculated risks and can’t be totally risk averse.

Here we will help you understand the trade-off between risk and reward, and also help you understand where on the risk-return spectrum some popular investment options fall.

The trade-off between risk and reward

Many a wise person has shared their wisdom to the effect that “if you want to achieve lofty goals, you have to take some risk.” Usually, the goal is compelling and rewarding enough for us to willingly take on the risk. However, we think of ways of mitigating the risk through some kind of damage control so that we don’t end up suffering if the risks were to materialize.

For instance, lets say our team is batting second in a one-day cricket match where the opponents have set us a very demanding target of scoring 400 runs in our allotted overs. If our team just scores singles and doubles, it might be safe, but we will fall dramatically short of achieving our target.

By taking no risk, we might conserve wickets, but we are almost sure to lose. To achieve this lofty goal of scoring 400 runs, our team will have to take risks. We will have to swing for the fences. Only then can we have some hope of reaching our target. In summary, scoring 400 runs (or earning a high return) while taking no risks is going to be almost impossible.

The same is true for investing. Earning a high return but while taking on very low risk is not possible. It’s a balance that even world-class investors struggle to achieve. Investment history has shown that you just cannot have it both ways - you generally get high returns only when you take higher than usual risk.

Take calculated risks – reward must be compelling

Exposing oneself to risk is not something one should do blindly. It must be done in the context of what the expected pay-off might be. If the reward is compelling enough, then it probably makes sense to take on the risk. Otherwise, it is not worth it.

Let’s take an example from everyday life. Wearing a seatbelt while driving is compulsory. Yet, many of us choose to drive without fastening our seatbelt. This exposes us to numerous risks. However, taking on these kind of risks has very little upside or payoff, but clearly disastrous consequences if the worst were to happen. This kind of a risk, which has no upside, is not worth taking.

Contrast this with the batsman chasing 400 runs who tries to hit every other ball to the boundary, with a degree of power and placement. Sure, there is a risk of getting caught but this risk is probably one that is worth taking because the payoff of scoring a six and chasing down the target is rewarding enough.

The big takeaway here for all of us here is that risks should only be taken when there is an upside and the expected payoff is rewarding enough. This is a lesson we must remember when investing our money.

Risk across the investment spectrum

Let’s take a look at common investment options and their risk reward trade-offs. The following will help illustrate how we as investors expect higher returns as the risk associated with the investment increases.

Let’s say I have Rs. 10,000 to invest into a fixed income instrument, an instrument that will give me a fixed return that is pre-set at the time of making the investment. I am considering 3 options: investing in a fixed income security issued by the government or a government backed entity, investing in an FD issued by a bank, or investing in an FD issued by a company.

The government security will pay the least amount of return (the reward) because it is least risky. It is backed by the government, and all things being equal the government ought to be a safe party to loan money to.

The bank FD will pay a slightly higher return because the government guarantees only part of the deposit so there is the risk of the bank failing, even if it is a very small risk. However, the company FD will pay the highest return because the risk perceived in lending to the company is the highest, so we expect a slightly higher reward for it.

What we are trying to demonstrate is that as the riskiness of the investment increases, so does our expectation of return. As a corollary, if we set out to earn a high return, please recognize that this will come at the cost of taking on a higher risk.

As one moves from holding cash in a bank savings account that earns only 3.5% return towards equities that are expected to earn up to 12% in the long-term, the riskiness of these different types of investments increases.

No pain, no gain

For those who frequently go to gyms, the idiom “no pain, no gain” is probably a familiar one. In the investment world as well, if we want gains, it’s going to be possible only when one takes some risks. Almost every investment option involves taking on some risks. Taking risks, albeit in a calculated manner, is something that is advisable, depending upon one’s personal situation.

Just like not every one has the capacity to lift weights of up to 40 kilos in the gym, not every one has the capacity to take on high risks. You must take on risks according to what your risk appetite allows you to do, and what you feel you comfortable about.

So next time you are looking to invest money, do keep in mind that there will be “no gain without pain”. Be realistic and don’t expect to get high returns unless you take on some risk.

VIJAY POPAT
www.vijaypopat.blogspot.com