More risk doesn't mean more reward

Jan. 20, 2013  |  Comments
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Investors sometimes ask about the nature of the trade-off between risk and return. In the "real" world, the saying, "There is no free lunch," is often used.

If in the financial world there truly is no free lunch and the only way to increase returns is to assume more risk, then why is diversification, which reduces risk, so often used and desired by investors? The answer is most probably that while an investor can increase his expected returns by assuming additional risk, it is not true that by assuming additional risk one will automatically increase expected returns.

This distinction is true not just in financial markets, but in life as well. A person can cross a busy street by checking traffic and then entering a crosswalk, a calculated but reasonable risk with the expectation of arriving at the other side of the street. On the other hand, one can carelessly walk into the street not using the crosswalk without looking. The chances of arriving safely on the other side are reduced, but the potential reward is no greater. Which do you think most pedestrians choose?

In the financial markets, reckless or "bad" risk can be identified and reduced through deliberate diversification. Once that is done, the portfolio is left with risk that cannot be diversified away. If the historical performance of the markets hold a reasonable guide into the long-term future, then one can expect to be compensated with higher returns for bearing that risk.

Company-specific risk is the risk of investing in an individual company. Random events can significantly affect the company - lawsuit, fire, death of key person. If the event was dire enough, an investor could lose all or most of their investment in the stock. Industry-specific risk is similar, except that it refers to broader economic events and negatively affect the entire industry. For example, in 2000, technology companies suffered declines far greater than the rest of the stock market. Both types of risk are diversifiable. If one owns hundreds of stocks in many different industries, "bad" news affecting one particular stock or industry would have a chance of being offset with "good" news emerging from another firm or industry in the portfolio. The methodically constructed portfolio could only be rendered worthless by the economy collapsing.

Therefore, it is very difficult to dispose of risk associated with the entire market. This market risk is the risk common to most if not all stocks, such as business cycle movements - recession or depression. You could purchase an S&P 500 Index fund, eliminating all company and industry specific risks associated with the firms held by the fund. However, you would still be subject to the movement of the broader stock market.

In conclusion, just as there is no guarantee the pedestrian will cross the street safely, even if using the crosswalk, there is no guarantee that an asset class will provide the investor with returns greater than the overall market, or even with positive returns.


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