Risk and Return (August 2011)

After another disastrous day in the stock market, I feel it may be helpful to review the relationship between risk and return in order to help put things in perspective.

Risk and return are positively correlated. This means that, if you assume no risk, you can expect to earn a rate of return commensurate with taking no risk, which is known as the risk-free rate. For example, if you were to exclusively invest in bank CDs, over the last few years you might have earned an annual compounded return of 1%. That is a low rate, but it is guaranteed, and you would never have experienced a fluctuation in your market value. However, at that rate, it would take 72 years to double your money. Most people do not want to wait that long to accumulate a sizable nest egg. That is one great reason so many of us decide to take some risk in the hope of earning a higher rate of return. For example, earning 7% per year would allow us to double our money every 10 years, which is a lot more attractive than waiting 72 years for the same results!

So, most of us consciously decide to take some risk in the hope of earning higher rates of return and seeing our nest eggs grow more rapidly. But risk is defined as uncertainty; that means we don't know what might happen; we don't know what rates of return we will actually earn--there are no guarantees. We do know that, as a reward for taking risk, the financial markets should compensate us by giving us a premium over and above the risk-free rate over time. Otherwise, nobody would be willing to accept risk.

Mathematically, risk is defined as a deviation from the average. That implies that sometimes we will earn above the desired average and sometimes below it. Suppose you are aiming to earn an average annual return of 7%. Two years in a row you might have earned 14%, and on the third year you may lose 7%. The average for the three years? 7%.

Psychologically, when we earned 14% two years in a row, we may come to expect that as normal. And when we lose 7% in one year, we may panic and make decisions that might not be in our best interest. We must remind ourselves the reasons we assumed risk in the first place, to earn a higher rate of return over time. That is, when we initially set on a course to try to achieve a higher rate of return than the one available in risk-free investments, we were willing to assume the uncertainty and volatility that comes with risk. Let's be consistent and stay the course. George Washington did not give up after his loss in New York.

In the last two weeks, the markets are off more than 15%--a financial calamity, of course. But let's not forget the big picture: risk is a deviation around the mean. Presently, we got hit with a negative deviation. It is likely that in the future, we will see positive deviation from the mean, and eventually, we will see the higher rate of return we expected. Let's be patient and confident in our belief that we shall be ultimately rewarded with a return premium for having consistently taken prudent risks.