Most seasoned investors are familiar with the concept of risk and return. If an investment like a stock has a higher risk associated with it, it’s sometimes assumed that there’s likely a higher potential return. Dig a little deeper and you’ll see this isn’t necessarily true.
When it comes to investments, not all risk is created equal. Not all risky assets have high expected returns.
This is particularly true of assets that have non-market risks. For example, the stock of a company that’s undergoing a major transition or experiencing a scandal (think Enron). These are company-related risks and not related to the market. You’re not guaranteed to get high returns. This is one reason why it’s important not to hold too much stock of a single company.
To illustrate this point, consider three different kinds of assets. One is a bond that has a guaranteed $5,000 payoff next year. The other two are “coin-flip stocks”: One will pay off $10,000 if it lands on heads (but $0 for tails). The other will pay off $10,000 if the same coin flip lands on tails (but $0 for heads). The consensus is that bonds are less risky than stocks, but in this instance, that’s not the case. The random risk associated with the coin-flip stocks can be diversified away.
Hold just one of the coin-flip stocks and you’ll have a 50% chance of earning $10,000 and a 50% chance of earning nothing at all. But if you hold both stocks they diversify the risk. You can be confident that you will earn $5,000 — the same return promised by the less risky bond.
As Christopher Jones, chief investment officer of Financial Engines, writes in his book The Intelligent Portfolio, “As long as the additional risk is not correlated with the overall market, you should not expect any additional expected return. You can eliminate risks not correlated with the market by holding lots of different kinds of assets. On average, the non-market risks — those risks that are not correlated with the overall market — will cancel out. So while high expected return assets always come with risk, not all high-risk assets come with high expected returns.”
Determining which investments are unnecessarily risky is a complex process.
This is why it helps to have an expert on your side. Understanding these fundamentals is a good place to start:
- Not all risk comes with expected reward. Market-correlated risks are compensated with higher expected returns. You can diversify away other forms of risk.
- There is no reason to take on investment risk unless you are being compensated for it.
The bottom line? That adage about risk and return being directly related isn’t necessarily true in all cases.
A well-thought out investment strategy understands this and takes it into consideration.
This post is based on Chapter 2 from the book, The Intelligent Portfolio, by Christopher Jones, Financial Engines’ chief investment officer. The content has been revised for the purposes of this blog.