What could possibly go wrong?
At the Standard Chartered Wealth Management CIO Office, we have the opportunity to meet a range of investors, representing a wide swathe of investment styles, goals, time horizons and perspectives on financial markets. We channel this diversity of views into our investment process. From these interactions, one difference in approach to investing stands out. When considering a basket of investments, many individual investors tend to have a disproportionate focus on the expected return, while institutional investors and research analysts tend to focus on the risks. The expectation of an attractive return is undoubtedly what motivates many investors to take on the risk necessary to make such investments. However, the risk-focused approach raises an interesting question – is it more appropriate to assume that returns will ‘take care of themselves’ as long as investors ensure risks are managed well?
What, exactly, is risk?
The term ‘risk’ is often used loosely in many investment conversations. Peter Bernstein’s Against the Gods: The Remarkable Story of Risk offers possibly one of the best overviews of the topic. For most investors, though, two relatively simple interpretations may be the most useful.
The first is the volatility of one’s investments. This is how most investors most commonly tend to define risk. History shows that equities have outperformed bonds and cash about two thirds of the time. However, these gains did not happen in a straight line. They come with ‘volatility’, because of which many investors accept lower returns from cash or bonds, or even prime real estate, in return for the comfort of the lower volatility, or ‘risk’, of those returns.
A second interpretation of risk is the likelihood of achieving those longterm returns within a given timeframe. While this is related to the first, longterm average returns are not the same thing as achieving those returns in a specific timeframe.
The focus on returns
What does a singular focus on returns lead to? The chart above illustrates one way of focusing on expected returns, based on history. This lens naturally leads an investor towards riskier asset classes – after all, if you could have earned more than 10% annual returns on small-cap equities in the past, why bother with asset classes like investment grade bonds that struggled to achieve 4%?
This view, of course, ignores the obvious risk that small-cap equities, at one extreme, delivered these historical returns with considerably more volatility than investment grade bonds, which would have been relatively stable through time. This links to the first kind of risk, the volatility of the asset class. Some investors may be quite comfortable riding out the volatility for the likely returns on offer, but we also know that not all investors are able to stomach the levels of volatility that accompany such returns.
What are my chances?
A second lens asks a slightly different question – what is the likelihood of achieving a positive return over a given 12-month period? Unsurprisingly, cash achieves a positive return 100% of the time, with investment grade bonds not far behind. Small-cap equities, though, were able to deliver a positive return only about two thirds of the time.
Clearly, asset classes that historically delivered high average returns pose a greater risk of not being able to deliver those returns in a given period, compared with ‘safer’ asset classes like cash or investment grade bonds.
The importance of getting risk right
There is nothing wrong in considering expected returns as a motivating factor for choosing one’s investments. For many investors, this is still an important starting point.
However, financial market history has illustrated time and again that predicting expected returns is a difficult exercise at the best of times. Our examples also help illustrate why it is an incomplete assessment of whether a basket of investments is suited to a specific goal. In our view, assessing which risks are worth taking and which ones are worth avoiding or hedging away is an equally, if not more, important part of analysing an investment, compared with a singular focus on the expected return.