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Thoughts on risk

When investors talk about stocks, the focus of the discussion tends to be on which stocks have the potential to do well, and that is understandable. When fund managers talk amongst themselves, the conversation typically follows a similar line.

Something that probably doesn’t get as much attention as it deserves is portfolio risk management. Risk management can make for boring conversation, but it is an important topic for investors who hope to succeed over long periods of time.

In fact, in one sense, risk and return can be thought of as the same thing. This is best illustrated with an example. Imagine that you have two investments: one is an investment in a stock market index that is expected to return 10 per cent p.a. with a moderate level of risk, and another that is expected to return 8 per cent p.a., but with a much lower level of risk. Let’s say it has half the risk of the stock market index. Let’s also assume an interest rate of 5 per cent.

As a long term investor who is happy to accept the ups and downs of the stock market, you might think you are better off taking the 10 per cent p.a. return, which should result in a better long-term result. However, here is another way of thinking about it.

$100 invested in the first strategy has an expected return of $10 over one year, whereas $100 invested in the second has an expected return of $8 over one year. However, consider a strategy of investing $100 in the second method, and also borrowing an additional $100 at 5 per cent interest and investing that as well.

You now have $200 earning 8 per cent p.a., which gives you an expected return of $16. You will need to pay $5 of interest on the borrowed money, so your net return will be $11.
That $11 is better than the $10 you could get in the index, but what about risk - doesn’t the leverage make this a risky strategy? In this case, the answer is no. If the 8 per cent strategy has half the risk of the 10 per cent strategy, then in simple terms you can invest twice as much into that strategy and still have the same total level of risk. In other words the leveraged approach that that gets you an $11 return has the same risk as the first strategy that gets you $10. Now which one should you prefer?

The point of all this is that risk and return can - to some extent - be thought of as substitutes for one another, and reducing risk can be worth just as much as getting a higher return. The consequence of this is that you can’t sensibly measure one without knowing something about the other.

This concept can become important when comparing different fund managers. There is a tendency in the industry to rank fund managers on the returns they achieved over (for example) the last 12 months, with little regard to the risk taken to get those returns.

But managers have very different styles. Some will try to hit the ball out of the park by taking large bets on particular companies or themes. When those bets succeed, that manager will be at the top of the league table (and will tell all and sundry about it). When they miss, the manager will be at the bottom (and stay relatively quiet). Managers who take a more cautious approach are less likely to be at either extreme.

Because of these differences, making performance comparisons is not a straightforward business. It is important for individual investors to think carefully about how position sizes, and in what circumstances they will hold cash or use leverage. It can be even more important in assessing fund managers: a manager who earns a performance fee in years when they <do> hit the ball out of the park is not going to give it back the following year if they strike out. As a result, high risk fund managers can impose substantial hidden costs on unwary investors.

 
Roger Montgomery
Roger Montgomery

Roger shares his stock market insights at his Insights blog, blog.rogermontogmery.com. Investors can also follow Roger on Facebook and watch media interviews at his YouTube channel. Grab your Second Edition copy of Value.able and learn how Roger Montgomery values the best stocks and buys them for less than they're worth. Grab the book now at special price!