Risk and Reward

TO EARN HIGH RETURNS, we need to take high risk. This is the fundamental tradeoff that every investor has to wrestle with: Are we willing to run the risk of large short-term losses in the hope of clocking superior performance?

That tradeoff is more complicated than many investors realize. For starters, we aren’t talking here about crazy risk, such as betting everything on one or two stocks. That’s as likely to leave us penniless as make us a mint. Instead, we’re talking about the risk associated with broadly diversified portfolios that might include hundreds of different stocks and bonds.

How are we measuring the risk of these broadly diversified portfolios? Traditionally, experts have relied on volatility. A stock portfolio is more volatile than a bond portfolio, so—if investors are to be enticed to hold stocks—they need to be reasonably confident they’ll earn more than with bonds.

In recent decades, some experts have argued that volatility alone doesn’t fully capture risk. For instance, value stocks are less volatile than growth stocks, but they’ve delivered superior long-run returns. Why? Value stocks often have weaker fundamentals than growth stocks and hence there’s a greater risk of bankruptcy, so perhaps owners of value stocks are compensated for taking that risk.

Even if we take high risk—by investing heavily in stocks or investing heavily in value stocks—we may not get compensated for the risk we’re taking, even if we hang on for a mighty long time. U.S. stocks barely broke even over the decade through 2009. It took Japanese stocks 34 years to return to their 1989 peak.

While the range of possible returns is large with stocks, it’s much narrower with bonds and even more so with cash investments. If we’re unlucky with stocks, we could get cash-like returns and perhaps worse. But even if we’re extremely lucky with our cash investments, it’s almost inconceivable that we’ll get returns that approach the historical long-run return from stocks.

With publicly traded stocks and bonds, and with cash investments, we typically have some sense of the risk involved. It’s much harder with investments for which daily pricing isn’t available, such as real estate, timber, many hedge funds, venture capital investments and syndicated bank loans. A fundamental rule: If an investment holds out the prospect of high returns, there must be high risk—even if that risk isn’t immediately apparent.

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