Risk And Return

“In every bad thing there is something good” according to a Hungarian proverb and this page is dealing with a special case of the inevitable bad (the risk), the management of the investment risk.

Mr. Bogle might have thought like that because most people have no clear idea about the wealth destroying nature of inflation let alone the close correlation between risk and return.

But before moving forward let us see what is risk.

The Risk (According to Wikipedia): 

“(Exposure to) the possibility of loss, injury, or other adverse or unwelcome circumstance; a chance or situation involving such a possibility."It is created by a peril.

In my opinion, the classical risk management chart applied to investment looks like as follows:

According to the above chart we can manage the investment risk in six different ways:

• We can ignore it, not dealing with it at all, we might even believe it does not exist. For example, in case of a unit linked insurance we believe we insure ourselves but in fact we rather invest.

• We may try to avoid it by not investing, but the inflation anyway consumes our money.

• We may want to transfer it but there is no cost effective way in investment to do so

• We accept it. This is correct.

• We exploit it. This is correct.

• We try to decrease the risk by optimizing it to our situation. This is also correct.

Acceptance of risk means taking investment risk in anticipation for an appropriate level of expected return. As usual, the golden mean is the optimal strategy in taking risk, too, but this can mean a different thing to different individuals as you will see in greater details at risk profile. Individual investment risk taking must remain on an optimal level, it can not be less (too cautious) or more (too agressive) than the given person is willing or able to bear. People generally speak about the return part of the investment easily, but when risk becomes apparent, they react emotionally. Since 2008 people have become much more aware this could happen, but they are still looking for low risk- high return perfect investment. People are still looking for weight loss pills whilst taking of which they could still afford eating juicy meat dishes, giant cookies and ice creams.

None of them exist.

Th PROBLEM lies in lack of understanding.

The main reason investors do not earn market returns is the lack of understanding that risk and return are related.They naturally strive to earn returns without taking risks whilst not understanding that the source of return is in fact the risk itself, therefore they would be better off paying attention to the risks associated with their investments.

According to the basic concept of risk and return, if the risk of investment grows the return expected must also grow in line with it, due to risk premiums. Investors can not expect higher returns without acceptance of higher level of risk.

However, not all risk taking is rewarded by markets. Investment risk can be measured many ways, e.g. by fluctuation of the value, partial or even total loss of the investment. There are two types of general risk associated with each stock.

The first is specific, or unsystematic risk which is an industry or firm-specific threat in each kind of investment. These are risks which are existing but are unplanned and can occur at any point causing widespread disruption impacting this industry or firm but not the whole economy.Recent example is the crash of two Boeing 737 Max airplanes causing a significant drop in the stock price of Boeing. As this risk is diversifiable, therefore investors are not paid compensation for bearing it.

The second general type of risk is inherent risk existing in the stock market. These risks are applicable to all the sectors but can be controlled. If there is an announcement or event which impacts the entire stock market or asset class, a consistent reaction will flow in which is a systematic risk. This risk can not be treated by diversification and is called systematic risk.In fact, higher expected returns are compensation for bearing such systematic risks.

Academic research has largely contributed to achievements in modern finance.

This is the level science of investing has achived by today. It is worth pursuing investment opportunities that aim at higher expected returns by tilting to dimensions described above.Unfortunately, funds constructed this way are not yet available in Hungary, therefore one can only buy them abroad.