24/07/2024

The CTO

The Best Chief Technology Officer

Risk and Reward

Risk and Reward

In the field of investment risk and reward are a bit like Frank Sinatra’s love and marriage, you can’t have one without the other. The reward of an investment is pretty obvious, it’s what you make on it and come from either capital appreciation, income, or both.

Risk may not be quite so intuitive to grasp. We may instinctively think of it as being the chance that the investment will fail, ie our capital will be completely lost, or even (in the case of leveraged investments) that we shall end up in debt. More accurately risk describes the volatility of a particular investment, ie the degree to which its value fluctuates. Mathematically this can be measured by a statistic called the “standard deviation”.

In general, the greater the (potential) reward, the higher the risk.

There is no such thing as a risk free investment. If you keep your money under the bed it may be stolen by burglars or eaten by rats, not to mention the inevitable erosion of its value by inflation.

If placed on deposit at a bank you will at least gain interest, but again inflation will erode its buying power, and there’s always the risk – however slight – that the bank will fail.

Probably the lowest risk of all is offered by government issued index linked bonds. But even these have the risk their returns may be outstripped by alternative investments (and the minute possibility the government might default).

Moving up the scale of risk lie corporate bonds. These should offer a known rate of return, but their capital value will fluctuate with interest rates as well as the likelihood of repayment. These encompass a whole spectrum of risk depending on the issuer. An indication of the risk is given by bond ratings such as Moody’s and Standard & Poor’s.

Common stocks also encompass a wide spectrum of risk, with steady but unexciting blue chips at the safe end and aggressive start-ups at the other. One indication of the risk of a stock is its beta value. This indicates its degree of volatility compared to an index (or basket of stocks). A beta of 1 indicates it moves (more or less) in line with the index. A beta of greater than 1 means it is more volatile than the index while a beta lower than 1 means it is less volatile. Of course beta is calculated on past performance which may not continue into the future.

Most risky, but with the greatest reward potential, are derivatives and leveraged investments where you are risking more, sometimes much more, than your initial stake.

Know Thyself

In reality each individual’s portfolio will consist of a mix of investments at varying positions in the risk-reward plane.

Ideally we should all have 2-6 months living costs in a quick access cash deposit account as rainy day money. Beyond this how we allocate the remainder depends on i) our objectives, ii) our circumstances, and iii) our personal risk tolerance.

Our objectives are the reason we are investing. Is it to put a deposit on a house, for kids’ college fees, for retirement…? The further away the objective (circumstances) the greater the risk is acceptable.

But two people with exactly the same objectives and circumstances may plump for different portfolios depending on their unique psychology for risk. Some people are more tolerant of risk than others. As a rule of thumb, if you’re going to lose sleep over it, don’t do it.

Diversification

Modern portfolio theory is a mathematical treatment of the risk-reward issue. It says that risk can be reduced by diversification (ie holding different investments that tend to experience highs and lows at different times). It further says that any risk that can be mitigated by diversification won’t be rewarded by additional returns. That is the market expects investors to allocate their funds as efficiently as possible to reduce risk through diversification and if they don’t, tough, they won’t be rewarded for unnecessary risk.

This means you shouldn’t put all your funds into just one or two stocks. The easiest way to do this is through a tracker fund or ETF (Exchange Traded Fund). I don’t recommend managed mutual funds as management fees tend to educe the rewards below those offered by passive alternatives (trackers and ETFs).

If you choose to hold individual stocks then hold a sufficient number of different ones. Bearin mind that as you hold more the additional benefits of each reduces. For an individual investor I’d suggest around 8 to 16. Too few and you carry too much risk if one were to suffer a downturn. Too many and they become difficult to manage as well as being subject to higher commission costs.

Bear in mind too the correlation between stocks. If, for instance, you hold 8 supermarkets you won’t have diversified very well because the supermarket sector is often likely to move in the same direction. Instead try to choose stocks that are likely to move independently, or even opposite, to each other. A good example would be an ice cream maker and an umbrella maker for whatever the summer weather one would likely do well.