Investment Risk and the Risk/Return Tradeoff
The Investment Risk/Return Tradeoff and the Dangers of Market Timing
What Is Investment Risk?
The Technical Definition:
Investment risk is a measure of how far the actual return can be expected to vary from the expected return in any given year. We calculate investment risk by measuring how far the actual return has varied from the average return over an historical period.
Investment risk is measured using a number called standard deviation. Standard deviation marks the range within which the actual return will fall 67% of the time. For example, a portfolio with an expected return of 10% and a standard deviation of 20% will have a 67% chance of generating a return of between -10% and +30% in any single year. To calculate a 95% probability, just calculate returns using two standard deviations. So the same portfolio with an expected return of 10% and a standard deviation of 20% has a 95% probability of achieving a range of returns of -30% to a +50% return. (2 * standard deviation)
The not technical or How most people define risk Definition:
Risk is the possibility of losing money. This definition only recognizes risk on the downside. It is important to remember that volatility works on the upside as well as the downside. We all want low volatility on the downside and high volatility on the upside.
What is the Investment Risk/Return Tradeoff?
The investment risk/return tradeoff is one of the cornerstones of financial theory. In short, it means that to increase your expected returns you must accept increased investment risk or volatility. This makes sense when you think about it. Investors will tend to flock to those investments that offer the best return with a given level of investment risk. The higher return these investors want, the more investment risk they are willing to accept.
CAVEAT: HIGH INVESTMENT RISK DOES NOT GUARANTEE HIGH RETURN. Just as with more investment risk you may achieve higher returns, with more risk you could also lose more. Markets do not just go up and businesses do fail, products become obsolete, market shares erode, competition squeezes prices, economic conditions change, consumer tastes change, etc. So just because you decide to take more risk with your portfolio doesn’t mean that your returns will automatically be higher. The investment risk/return tradeoff is a general truism in the investment industry but it doesn’t ALWAYS work out that way.
What About Market Timing?
Many investors believe that by accurately predicting changes in the economy they can shift their investment strategies to outperform the market. This approach is called a market timing strategy.
The key phrase here is “accurately predicting,” which turns out to be much more difficult than it sounds. Remember, thousands of professional money managers are paid millions of dollars to spend their lives trying to outguess the market. Despite the awesome brain power focused on the problem, almost 90% of professional money managers underperformed the market during the 1980s.
One study has shown that market timers need to predict upturns and downturns accurately 80% of the time for market timing to pay. Consistent optimal asset allocation policy held for the long-term offers the best chance for the investor to achieve steady returns.
