People generally say the riskier the portfolio, the higher your returns will be. And that may be true to some extent, but that is definitely not the complete story. Because if that was true all the time, people would just buy the riskiest assets and expect huge returns year over year and there would be no risk. So what is the complete story? Why doesn’t everyone earn 100-200% year over year by investing in the riskiest asset out there?
To understand this better, we need to first understand what is risk? This is one of those things that is easy to define, and extremely difficult at the same time. In layman’s terms, anything that has a higher probability of going into a loss is more risky. People generally use volatility in measuring risk. The more volatile the investment, the riskier it is perceived to be. While this makes some sense because people are more likely to get out of a volatile investment than they are from a less volatile more stable stock. However, here is an example of how volatility may not represent accurately on how much risk is present in the stock.
The above chart is for company ABC and if volatility were an accurate measurement for risk, this stock would be risker at $7/share at point B compared to $31/ share at point A. How can the same company be more risky at a lower price and less risky at a higher price?
Now that we know how risk can be measured, let’s look at why is it not a good idea to keep investing in the riskiest assets and expect exceptional returns every year? Howard Marks summarizes it accurately, if riskier investments could be counted on to produce higher returns, they would not be riskier. Below is a graph that was used in his book “The Most Important Thing” to explain the true nature of risk and how someone could earn a higher return with lesser risk.
While people usually think a risk vs reward graph is more like the blue straight line in the above graph, in reality at each risk point, there is a range of returns that you could expect. The truth is that, with higher risk, you are opening yourself to a wider range on returns. Yes, you could potentially end up with a higher return, but you could also end up with a larger loss. Let’s take an example comparing two individuals, Jake and Raj. Raj understands that higher risk doesn’t always mean higher return, hence he chooses a portfolio with much lower risk compared to Jake, who thinks in order to earn higher return, all he needs is a portfolio with higher risk. After a few years of sticking with that portfolio, Raj ends up at point B and Jake at point A. It is clear that even though Jake took higher risk and could have possible ended at point C, he didn’t. In this situation, Raj who took lower risk ended up with higher return compared to Jake who took higher risk. This shows why you should not take on higher risk just to get higher returns.
- Jai Gandhi, Financial Planning Assistant
- Craig White, Investment Advisor and Portfolio Manager
Jai Gandhi is a Financial Planning Assistant at Endeavour Wealth Management with iA Private Wealth, an award-winning office as recognized by the Carson Group. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.
This information has been prepared by Jai Gandhi who is an Financial Planning Assistant for iA Private Wealth and does not necessarily reflect the opinion of iA Private Wealth. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.