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Understanding risk vs return

The idea of risk-return tradeoff is deeply ingrained into the way we think about investing. However, there are three problems

Understanding risk vs return

Risk versus returns. Nothing ventured, nothing gained. The idea that the higher returns you want, the more risk you must take is ingrained deeply into the way we think about investing. This is not just a concept or general rule of thumb anymore. There's even a Nobel that has been given out for work from which this risk-return concept can be mathematically derived.

Sharpe, Markowitz and Miller's 1990 economics prize was for work that underlies modern portfolio theory, of which I'm definitely not a fan. The idea that the risk-vs-return trade-off is quantifiable also derives from that work. Of course, it's beyond argument that there is a risk vs returns trade-off. People understand that instinctively. This is not even a financial phenomenon. Even in the prehistoric world, while Homo sapiens were evolving, those who took more risks must have been able to hunt more nutritious animals but with a higher chance of injury or death.

However, there are three problems. One, this risk-vs-return trade-off is not quantifiable, no matter what any Nobel awardee might say. Typically, financial-planning advisors or robo-advisory websites try to ask you some questions to try and judge what they call your risk tolerance. Generally, these questions are along the lines of how much of a temporary loss you feel you can tolerate over a certain time. This doesn't work.

The risk-vs-return idea of portfolio theory is not transferable to human beings. The risk level a human being can tolerate is not a measurable constant. It can, and does, change quite frequently. Your risk tolerance is actually a function of everything else that is going on in your life. If any other part of your life starts looking shaky - it could be your business, your job, yours or a family member's health, the state of your other assets - then your risk level could increase. And of course, the reverse is also true.

However, this is just the first big problem with this idea. There's the second, which is that what we call risk is actually variability of returns. An investment with a high variability doesn't always deliver high returns. Variability means that it can deliver low or negative returns. In fact, a low-risk investment can generate returns that are higher than a high-risk one. That's part and parcel of risk. The connection between high returns and high risk is probabilistic. The chances are that high returns come with a higher risk but that's it - it's a chance, a higher probability, that's all.

The third problem is even more subtle. An investment that has the chance of a higher return is likely to have higher risk. However, the reverse is not true. High risk by itself does not mean higher returns. There are plenty of investments that have a high risk but no chance of high returns. So don't make a mistake about which is the cause and which is the effect. High returns often come with higher risk. High risk may or may not come with high returns.

At the end of the day, as an investor who is putting money into equity-based funds and perhaps even in equity, you must be aware of the sources of risks, your tolerance to them and how the risks can be mitigated. The biggest pay-off of handling risk is that you won't sell off and run away when the markets decline. That alone can severely impact your returns.