We had a routine meeting with a prospect this week and they said something which is very commonly said in our industry. They were previously managing their own money and they said that they had always wanted to maximize their risk in the past, because with higher risk comes higher returns. As I said, this is a very common thing that is said in our industry by advisors, money managers, and yes even clients. The funny thing is: it is completely false.
Before I break down why this is a false statement, it's worth talking a little bit about what exactly is 'risk'. I think if you were to ask most of our clients what risk is, they would say that risk is the chance that they will lose money. I think this is pretty close to the true definition of risk, but it's not quite complete. My definition of risk is, "the chance that I will be unsuccessful in trying to increase my purchasing power over time". In layman's terms, this essentially means the chance that I will lose money after inflation over time.
This is a pretty straightforward and accurate definition of money which I think aligns with most of our clients' goals and objectives when it comes to investing. Unfortunately when investment advisors and other finance professionals talk about risk, they are often using a completely different definition of risk. When they say risk, what they actually mean is volatility, or the amount an investment's price will fluctuate. Volatility is measured by metrics like standard deviation. Essentially an investment where the price fluctuates a lot will have a higher standard deviation. When you look at a mutual fund's information sheet and it describes the fund as high risk or low risk, what that really means is high volatility or low volatility. Using volatility as a proxy for risk leads to some absurdities which investors should be aware of.
For example let's look at the stock price of one of the original blue chip stocks: General Electric. According to traditional measures of risk which are based on volatility, GE's stock was less risky in December 2016 at $32.38 a share then it was in December 2018 at $6.66 a share. Source: https://www.morningstar.ca/ca/report/stocks/performance.aspx?t=0P000002DO&lang=en-CA
That of course makes no sense. It's the same business only 2 years apart. How can it be safer to pay $32.38 a share than to pay the much lower $6.66 a share 2 years later for substantially the same business? In fact, the only rational way to look at this chart is to say that the inherent risk in the company was present in December 2016 just before the stock price dropped. That risk would not have been measurable by volatility measures, because the volatility of the stock up to December 2016 would not have been that high.
There's two important lessons we can draw from this example:
Advisors always warn that past performance is not indicative of future performance. Well that also applies to past volatility. Just because a stock's price has been relatively stable in the past, does not mean that it will be stable in the future.
A risk measurement solely based on volatility is incomplete and will not tell you the total amount of risk in an investment. For this reason, you cannot rely solely on risk descriptions solely based on volatility, which are commonly found on marketing materials for mutual funds and ETFs, and are used almost exclusively by many investment advisors and other financial professionals.
So if measuring volatility won't tell us the risk of an investment, how do we determine what the risk is? Well the simple response is, there is no easy way to determine the precise amount of risk in an investment. Risk is inherently unknowable because it involves predictions about the future. We can make reasonable predictions about the risk of an investment, but in the end we are never going to be able to say with the complete certainty and precision what the amount of risk is.
However, that doesn't mean we're helpless in determining risk. There are lots of analysis we can do to determine if a company is a higher risk or lower risk investment. Companies that have a long track record of profitability, low amounts of debt, consistent dividend payments, and a competitive advantage or moat around their business is more likely to be a low risk investment than a company with the opposite characteristics.
One thing is for certain though, if we want to lower the possibility we will lose money, then we should try to pay the absolute minimum purchase price possible for any investment we make. The higher the price we pay, the more risky the investment becomes. What is also true is that the lower price we pay, the higher our returns should be, all else being equal.
So if we go back to the original statement that in order to achieve higher returns, we have to take on higher risk, you should now see how that statement is completely false. In fact, the statement should say, "with lower risk comes higher returns." Lower risk means buying at a lower price. Buying at a lower price could mean potentially higher returns. What people really mean when they say that higher risk leads to higher returns is that higher volatility potentially leads to higher returns. But as we've seen, volatility and risk are not the same thing.
- Craig White, BA, LL.B., CIM
Craig White is an Investment Advisor at the award winning firm Endeavour Wealth Management with Industrial Alliance Securities Inc. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.
This information has been prepared by Craig White an Investment Advisor for Industrial Alliance Securities Inc. (iA Securities) and does not necessarily reflect the opinion of iA Securities. 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.
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