Risk is good, but only if you get paid for it

It’s not news to tell you that, in order to have a higher expectation for returns, you have to take more risk. This is an age-old truism, and is the fundamental reason that our financial system exists. The financial system - from banks to brokerage firms to mortgage companies - is structured around the simple premise that money needs to be shifted from those with little appetite for risk to those with a higher appetite. By this mechanism, bank deposits (low risk) are used to provide the cash to make loans to companies (higher risk). And so on.

Does it then follow that taking more risk will increase your investment returns? Oh, most certainly not. That statement is a bit of rhetorical slight-of-hand that has lured more than a few unsuspecting investors into disastrous decisions. Note that I turned the sentence around backwards. In the introduction, I said that (a) in order to have higher expected returns, (b) we must take more risk. In the second instance, I said that (b) if we take more risk, (a) we will expect higher returns.

In mathematics, we would call the linkage between the two parts of those statements a “necessary, but insufficient” condition. While it is necessary to take risk in order to expect higher returns, that risk is not necessarily sufficient to ensure higher returns. Just because B follows from A doesn’t mean A follows from B. If you follow me.

In our mind’s eye, we see the risk-return relationship as moving upward and to the right. You have surely seen this little chart in financial magazines and on mutual fund Web sites. As you run your finger across the bottom of the chart, increasing risk, the line on the chart moves up and to the right, indicating higher returns. It is very easy to then say, “OK, I’ll have this one right here,” selecting a spot out toward the end where the returns are nice and high.

What the chart-makers forget to tell you is that the line on the chart represents the maximum return that is to be expected. Not the predicted return - the maximum possible return. Put your finger on that line and run it vertically down the page, all the way down past the bottom into negative territory. That is the range of potential outcomes to the risk level you are choosing. Choosing your risk level does very little to predict the outcome of your portfolio results.

I field inquiries from clients and investors all the time about portfolio risk. Mostly, they ask about increasing their risk. Seeking higher returns, they ask me how to add risk to the portfolio. Adding risk is the easy part - I can do that in a moment by throwing money into volatile asset classes that trade without regard to the underlying fundamentals. However, I will warn them that I expect that this increased risk will reduce the expected return to the portfolio.

So, how is it that increased risk will reduce the expected return, when the standard chart shows returns that increase with risk? Because that chart shows the maximum possible return, based on historic averages. The problem is that we don’t live in average times, we live in these times. The price at which we can acquire higher-risk investments at this moment in time gives us an expected return that is far from the historic maximum. Current market conditions are such that the traditional upward-sloping risk-return curve is now flat or slightly declining. This is true whether you are looking at stocks or bonds or real estate - the Big Three of conventional portfolio construction.

In other words - adding risk to a portfolio in today’s market does almost nothing to increase expected returns. I want to increase returns as much as anybody. After all, I do this for a living, and the better I can do it, the better my business runs. I like risk. I merely insist on getting paid for it. There are times to ride the risk-return wave and there are times to sit on the beach. This is a nice time to sit on the beach. Enjoy your summer.