Risk, in Further Detail

Last time, we mentioned the word “risk” on several occasions. What is risk? On the one hand, we sort of intuitively understand what it means when we way: “This is a risky investment.” On the other hand, it would be nice to have a more precise definition of risk, especially in the investment context. We know that the movement of prices on the market is practically unpredictable. Stock prices change constantly, going up and coming down. We presume (and hope) that they will rise over time, but we are unable to predict what the price of a share will be in, say, a month. This unpredictability is related to risk.

Now, let us conduct a very simple experiment: imagine that someone owes you $10. They offer you two options: to either give you back the $10, or to toss a coin – if the coin lands heads, you get $12, and if tails – $8. Almost everyone would prefer to simply take the $10, even though on average, in the second case, you would still sort of get $10: either $12 or $8, both with a probability of 50 percent. But we do not like the uncertainty and prefer not to risk it. This is exactly the sense in which we will be talking about risk – as uncertainty about the value of our investments in the future.

Let us get back to our example. Suppose you were offered a different option: simply the $10, or toss a coin and get either $9 or $12, depending on how the coin falls. Many would agree to such an option: risk is risk, but potentially, there is money to be made here – after all, on average, you would be getting $10.50. We have just described a fairly fundamental principle: the connection between risk and return. This principle is extremely important and very general. And so, one more time: we do not like to risk, but are ready to do so under certain circumstances, if in return we receive a large enough reward. What is “a large enough reward?” It may be different for each individual investor, but therein lies the beauty of the market, that it represents an opportunity for people with different requirements and ways of thinking to freely buy and sell securities: someone could figure, for example, that certain stocks are too risky, while others will decide that the potential level of return at this degree of risk satisfies them, and they will buy the shares.

Previously, we presented some examples of how riskier classes of investments bring higher returns, and the other way around. This is such an important rule that I would like to offer one more example (the data was collected by the American Association of Individual Investors, which averaged the results for all stocks and bonds, not separating them into large or small ones, corporate or federal) for the period between 1946 and 1996, i.e. the past 50 years.

Source: American Association of Individual Investors

For this period, the average return on stocks was 12.2 percent. But few people keep their money invested for 50 years. As an experiment, the Association also calculated what the results would have been had investors invested their money in various types of securities for only five years, i.e. for example, from January 1946 to December 1950, or March 1970 to February 1975, and so on. It turned out that the variability of returns was immense. In the worst case, there was a period when over a five-year span, the average annual return on stocks was minus 2.4 percent, i.e. you had your money invested for five years, and ended up with less than when you started, about 12.6% less! And this is without accounting for inflation. This is quite the unpleasant result. On the other hand, in the best five years, the average return on stocks was +23.9 percent, i.e. over a period of five years, $1,000 would have turned into almost $3,000. What does this tell us? It tells us that the returns on stocks are poorly predictable, and the variability of their returns is high, in other words, risky. Now let us take a look at bonds. Their average annual return was 5.8 percent, much less than that on stocks. Their best five-year span brought an average annual return of 17 percent, and their worst – +1 percent for the year, i.e. even in the worst of years, bonds still delivered a minimal return. We see that the variability of returns on bonds is smaller than the variability of returns on stocks, i.e. they are less risky than stocks. Interestingly, if investors held money for 10 years rather than five, then the variability of returns would have been much smaller. In other words, the longer you keep your money invested in the market, the less risky your investment becomes. This is a very important consideration.

By the way, you may find a similar chart on our site, here. Visually, this information is easier to grasp.

Does this mean that it is not worth investing in the market? No, of course not. This simply means that these investments are accompanied by a certain risk that must be balanced against the investor’s means, what the investor’s tolerance to risk is, and for how long the money is being invested. We will talk about these things in our subsequent programs.

But with this, we will have to draw today’s program to a close. This was Sergey Zaks. Thank you for your attention and until next time.

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