Risk and return
To a gambler risk is a game. In commerce, risk creates wealth. In economics, it drives productivity. For investors, risk is something to be calculated then stared down. The normal language of risk and return is a bit too neutral for my taste. Risk is the name investors give to losing money.
Losing money is an extremely unpleasant experience. It takes you long enough to earn it, the last thing you want to do is throw it away. The waste of all that effort is precisely the opposite of a work ethic. Moreover, it makes you feel stupid.
Fear of losing money clouds our judgement when it comes to investing. Such is the premium we place on avoiding losing money, that we cling to near-zero risk investments, such as bank deposits, thereby missing the potential to make money. A proper understanding of the relationship between risk and return should replace fear with a more steely-eyed view of risk. Such is the aim of this tutorial.
Business Investment
Investment risk is the sum of the outcomes of business projects, which can be simplified into three broad categories:
There’s a few points to highlight from this table:
Low risk does not equal no risk; all business investment risks losing money. Many private investors would calibrate risk differently and consider any chance of losing money as quite a high risk investment. Businesses think differently; perhaps private investors should also.
Most business projects are medium risk; low risk investments such as rolling out successful products in new territories and building new factories are seen as ‘normal business’ for most companies. Aside from stellar internet start-ups, most innovations offer incremental improvements and come out of established companies that will not go out of business if the product fails. Such investments are medium risk.
High risk investments are a special case; the special challenges of high-risk investments require a higher-than-normal amount of management skill and talent. No one should consider a high-risk investment without being confident of the quality of the management running the project or company. Ideally, you should know them personally. This makes this type of investing the province of professional or specialist investors because most retail investors won’t have this type of access. In Private Equity they call this ‘alpha’.
Return on Investment
The table below offers a probability profile for a range of outcomes for projects in each risk category. The probabilities are based on personal experience and make no pretence at objectivity.
The basic arithmetic of this table is that, while the downside is limited by the size of your initial investment, the upside isn’t. So even though there is a much greater chance of losing money on any individual project, higher risk projects will return greater value, on average, than lower risk alternatives. In other words, the relationship between risk and return is, in essence, a statistical one. This in turn means the relationship need not be based on fear but on simple calculation.
Two elements of this calculation need highlighted. The first is that you need to hold a portfolio of investments to be sure of achieving the ‘average’ return. It is well established financial theory that above 20 investments, you eliminate most of the risk of individual projects having a disproportionate effect on your overall portfolio. The other element to take into account is time. The statistically expected ‘average’ outcomes from the table above are plotted over time in the figure below.
This graph shows the effect that losing money in a few individual investments has within the overall portfolio of medium or high risk investments: it lowers the return in the short-term compared with less risky investments. The higher risk investments underperform until a ‘break-even’ point is reached after 9 years. Thereafter the higher-risk investments outperform. The implication is clear: don’t invest in risky projects if you’re looking for a quick exit.
Validating this Risk-Return Model
The conclusions of this model of risk and return can be validated with the real world performance of the stockmarket. The table below starts with the after-tax expected average returns calculated from the probability table above. These returns are then converted into a P/E ratio, assuming 1.15% productivity growth in the future. The resulting P/E ratios mirror the real world quite closely, confirming the reasonableness of the model.
It’s interesting to note that, for brief moments during the recent financial crisis the P/E of the main markets did fall below 10, suggesting that investing in the stock market at these times was a high-risk under-taking. Valuations have recovered as investors’ perception of risk has improved.
For additional confirmation I looked at the returns achieved by private equity funds, which invest in highly-leveraged buy-outs and venture capital. Several different sources all point to an average ‘since-inception’ internal rate of return, (before fees, carried interest and tax) of about 14%, which is consistent with an after-tax return of 11% in high-risk investments. Similarly, the quoted UK venture capital firm 3i has a published target of achieving a before-tax return of 15% over any 5 year period which would translate to an after-tax return for an investor of 12%, which is also close to the return estimated in the table above. Whether they have achieved it is another matter, which underlines the management point made earlier.
Capital Asset Pricing Model (CAPM)
The CAPM gives a theoretical model for equating risk and return in which company valuations go up or down depending on whether base rates go in the opposite direction. Company valuations should only change if cash flows change and interest payments are not big enough to have the effect predicted by the CAPM. Although one of the founding theories of corporate finance, for which it’s inventor won a Nobel prize, it is unconvincing as a model of real-world risk and return.
Conclusion
Investment risk is nothing to be fearful about. Yes, some of the investments in your portfolio will lose money. It is an unavoidable consequence of being in business. But given enough time and a portfolio of sufficient size, investment risk should be highly profitable.