In all respects, the days of earning innocent money in the financial market were over with our learning about the risk-return trade-off. It took the work of many explorers of the fiscal wilderness such as Harry Markowitz, William Sharpe, et al, spread over many decades, to finally convince us that taller trees fall first during storms. Now, it seems almost like repeating the obvious when we say that high returns come only with high risk. That’s the only rule. Anybody discovering the exception—a chance of earning high returns with low risk—would surely deserve a hug from all angels in the sky.
Johnny: Before you explain the intricacies of risk-return trade-off, it would be better, Jinny, if you could explain what exactly you mean by risk.
Jinny: Risk is a kind of a wild card that disturbs all our plans. All our senses may not be enough to discern what exactly risk looks like but our past experiences are littered with its footprints. In general, we can understand risk as the chance or probability, or whatever else you like to call it, when the actual result does not turn out as expected. You fire a rocket and instead of going up it goes straight into your house. In investment parlance, you buy shares expecting the prices to go up, and instead the prices come down. So, no matter how carefully you make your investments, there is always a possibility that the actual return from your investment would be lower than what you expected. Risk means that there is always a chance of our losing in the game of investment. But risk does not strike all kinds of investments with equal force. While some investments are inherently more risky, some are inherently less. If you understand the risk level of a particular investment, then you can very well make your own plan for surviving the odds.
Johnny: How can we understand the risk level? How can we know which investment is more risky and which is less?
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Jinny: Look at the footprints. We make risk assessments based on past experiences. Statistically, risk is measured by calculating the standard deviation or how many times the actual results have varied from the mean. You need past data for such calculations. A higher standard deviation for an investment means that the actual returns have shown greater propensity to vary from the expected returns. In other words, we can say that the actual returns for the investment showing higher standard deviation are more volatile. Interestingly, investments of different kinds show different levels of standard deviation and consequently, different levels of volatility. This is the reason why different kinds of investments offer different returns.
If investments of all kinds were to offer the same return, then no one would like to invest in an asset giving a return that is highly uncertain. In order to sweeten the deal, the risky investments offer a higher rate of return so that investors are compensated suitably for making a risky choice. This compensation for riskier investment is called “risk premium” in common investment parlance.
In a nutshell, we can say that the greater the promised return, the greater the chance that the actual return may vary from the expected. But that does not mean that you can never earn high returns. You enjoy a good chance of earning the expected return but always keep in mind that there is also a good chance that some wild card may unexpectedly turn up and disturb your plan.
Johnny: How can we minimize the role of wild cards in disturbing our investment plans, Jinny?
Jinny: Well, make your plans only after understanding the risk-return trade-off of your investment. Always evaluate. How much more are you likely to earn by taking on more risk? If someone is paying you Rs100 for embracing a rabbit and Rs110 for embracing a gorilla, then is it really worth it? If yes, then go for it. But always avoid the temptation of putting all your money in one basket. Choose from a broader class of assets such as stocks, bonds, treasury bills, commodities that show different risk-return profiles.
Diversification, more than any other formula, really helps in striking a balance between the risk and return from different assets. On average, a diversified portfolio gives lower return but the overall risk of your portfolio is also less.
The real art of diversification lies in generating the highest possible return by undertaking the least possible risk. But of late, many sceptics have started casting doubts on the ability of diversification in really saving us from the onslaught of wild cards.
Jinny: Yes. But before explaining what the sceptics have to say, I think next week I will tell you about the Nobel Prize-winning work of Harry Markowitz, who really played an important role in making diversification a part of our investment life.
What: Understanding the risk-return trade-off helps in making the right investment decisions.
Why: An investment carrying higher risk generally offers higher return to compensate investors for the risk undertaken.
How: We can minimize risk by maintaining a well-diversified portfolio.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at firstname.lastname@example.org