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One of the fundamental concepts in investing is the relationship between risk and reward.
Broadly speaking, if you think you’re taking bigger risks, you demand greater potential rewards.
The promise of unusually lucrative returns on an investment should ring alarm bells. It’s not necessarily a scam, but it could be signalling higher risk.
Compared with saving cash, investing in stocks and shares has a higher risk of losing money. However, such risk needs to be balanced against the risk of not investing. Simply sticking money into a cash savings account exposes it to the effects of inflation – which nibbles away at it and could mean a worse result over the long run.
Different types of asset have tended – in the past at least – to be more or less volatile in terms of how much they swing about in price.
Cash is recommended to those needing access to their savings at short notice because it isn’t volatile. Although the purchasing-power of cash is affected by inflation, it usually changes fairly gradually. So the risk is low, but then so are your potential rewards.
Shares are more volatile, but holdout the prospect of higher returns. If you wanted your money back at short notice, there is a risk prices could be low after a downturn. As such, shares are more suited to long-term investing.
Bucking the trend
Naturally enough, investors are keen to maximise their returns while minimising the risks. To this end, financial advisors have developed techniques to identify investments that appear to buck the basic trend, by producing higher rewards for a given level of risk.
Such measures – like the Sharpe ratio and Information ratio – tend to be the preserve of investment professionals, but the idea behind them is simple enough. They express the risk-adjusted performance of an investment. In other words, how good the performance is relative to the risk taken.
Not just volatility
The methods sound scientific and the figures produced are very precise, but this doesn’t make them fool-proof. For example, these two ratios can only take account of past patterns (which may not hold in future) and secondly they associate risk exclusively with volatility.
But risk isn’t just about volatility. There are several types of risk commonly faced by investors. Risk may relate to the performance of an individual company you’re investing in – or the market as a whole. Risk may involve the movement in foreign exchange rates if you own an asset overseas, or to competence of people managing your investments. What these risks have in common is that they expose you to the possibility of losing money without hope of recovering it.
So, how accurately can one assess the level of risk in practice? Nobody knows exactly what the future holds, so no one can be certain about all the risks that lie ahead. That said, markets collectively make judgements about risk levels and set prices accordingly.
This is not to say they always get it right. Certainly, the people who should be best at assessing risk have got it badly wrong on occasion, from governments, to regulators and financial institutions.
As US Defense Secretary Donald Rumsfeld famously said in 2002: “There are known knowns; there are things we know that we know. There are known unknowns; that is to say there are things that, we now know we don't know. But there are also unknown unknowns – there are things we do not know we don't know."
No crystal ball
In other words, we can’t accurately predict all the risks that lie ahead.
When the majority of investors perceive risk to below, prices may rise, which in turn means the actual risk of losing money could increase.
Then again, when perceived risks are high, it can drive prices down to the point where the actual risk is low.
Sadly, the reality may only become clear with hindsight. This can all begin to sound scary, but it needn’t be. Embrace risk thoughtfully and it is as much your friend as foe.
Almost all investing decisions boil down to the interplay of risk and reward. If something looks too good to be true, it is probably because you are not seeing the risks.