Investing lessons are in session

The relationship between risk and reward is a cornerstone of understanding long-term investing.

As we saw in a previous lesson, the various asset classes – cash, bonds, property, equities and so on – sit on a continuum of rising risk and reward.

  • Cash is the least risky asset class – it’s often considered risk-free – but you also expect the lowest return from it.
  • Bonds are riskier, and over the long-term their historical returns have been higher than from cash.
  • Equities are the riskiest mainstream asset class. They’ve typically delivered the highest returns over the long-term.

Remember that when we say ‘risk’ here, we mean volatility – how much prices move around – although the risk most of us care about more – losing some or all our money – also applies.

Another – non-academic – way to think about risk is it’s the probability of something being worth less than you paid for it at some point in the future.

Cash in a bank never goes down in value. Shares can fall 5% in a day and crash 50% in a matter of months in a bear market, though that’s rare. But over the very long-term the returns from shares can be expected to trounce cash.

Why does this relationship hold? Because it has to.

Why risk taking usually pays in investing

If you think about it, why would anyone invest in a riskier asset class if they only expected to get the same return as from a less risky asset class? (And the latter with better sleep and fewer grey hairs, too.)

The odd person might make misguided bets.

But the market as a whole is considered to be rational and efficient, not an Edward Lear poem.1

If a riskier asset class appears to offer only the same return as a less risky one, then something has to give. The price of the riskier asset falls until it is cheap enough to offer sufficiently enticing expected returns to make up for its extra volatility.

  • Why would you put up with fluctuating bonds prices if you don’t expect higher returns than from cash?
  • Why risk the vertiginous death swoons of the stock market if you only expect to earn the same returns as from more stable bonds?
  • Zooming into specific shares, why invest in a risky start-up company if you only expect to get the same return as from an established blue chip?

In every case the answer is your expectation of higher returns.

In general the market does a good job of sorting out the pricing of various asset classes at any time to match buyers and sellers at the different risk/reward points.2

We investors can then bolt together portfolios from the different asset classes with the aim of matching our overall risk tolerance.

But here comes the important point. Academics – who came up with all this theory – warn that the relationship of more risk, more reward does not always hold.

In some circumstances you take greater risk, yet you can’t expect the market gods to reward your chutzpah with greater returns.

Academics these lousy bets uncompensated risk.

Uncompensated risk: Just say no

The classic example of uncompensated risk is buying shares in an individual company versus investing in the broad stock market.

Let’s say you expect shares in financial blogging firm Monevator Industries to deliver a 10% annualized return over the next decade.

Suppose you also believe the wider stock market will return 10% a year.

Now, there are many quirky things that can go wrong with Monevator Industries on the way to you earning your 10%.

  • It could suffer an industrial accident.
  • Its products could go out of fashion.
  • Its CEO could buy a new apartment and get distracted from running the business.
  • It could go bust.
  • At the very least its price is likely to move around a lot to reflect the market’s shifting assessment of these factors.

Of course, the stock market as a whole will also go up and down, too. Its various constituents will have their woes.

But all companies in the market should not suffer the same business disasters at exactly the same time.

If you’ve got all your money in one stock, you’re therefore taking on a lot more risk than the market – including the risk of losing all your money.

But don’t panic! Holding more than one company immediately diversifies your portfolio, and reduces this risk.

And the more additional companies you hold, the more the company-specific risk is diversified away.

Estimates vary, but holding as few as a dozen-to-20 different shares3 gets rid of the bulk of the company-specific risk. By the time you’re up to 50-100 different holdings you’ll have to hunt for the decimal point.

At the extreme you can just buy the whole market via an index tracker fund. Now you have diversified away all the company-specific risk. You’re just left with the risk of holding equities as an asset class.

Why uncompensated risk doesn’t pay

According to that academic relationship between risk and reward, a risk that can be easily diversified away cannot be expected to reward you with higher returns.

Why?

It goes back to supply and demand.

If investors can reduce the risk of investing in any single accident-prone company by holding a bunch of them, then the risk of investing in companies isn’t such a big deal, after all.

Investors therefore won’t demand so much extra expected return to entice them to buy. They’ll take lower returns and diversify.

Because the risk of holding a few individual companies can be easily diversified away like this and not be expected to give you higher returns, it is said to be uncompensated risk.4

As a consequences, you should not expect to earn higher returns simply from running a more concentrated portfolio of shares.

Note: I am not saying that you can’t make money investing in a single company’s shares. Clearly you can! You might have put all your money into Amazon shares at a few dollars and now be a multi-millionaire. Similarly, you might have lost everything in failed bank Northern Rock. In efficient market theory you can’t know which will happen in advance. You just know “shit happens”, and that you can diversify away the risk.

Another example is currency risk. This risk of currencies moving against you can be hedged away and the impact nets out over the long-term with a global equity portfolio, so it is considered to be another uncompensated risk.

Active management is a zero sum game that overall reduces returns to investors through fees and other costs. So some argue that it too is also uncompensated risk.

If you buy one fund, you might do better or worse than the market. The more funds you own – the more you diversify – the more that risk goes away.

Eventually this logic takes you back to owning a total equity market index fund, where you expect higher returns compared to a less risky bond fund, but no special extra returns on top.

Key takeaways

  • Generally-speaking, you will only get higher returns by taking on greater risk.
  • However greater risk cannot always be expected to deliver higher returns.
  • Risk that can be easily diversified away is called uncompensated risk.
  • The market doesn’t pay you for uncompensated risk.
  • Index tracking funds that invest across broad asset classes are an easy way to diversify.

This is one of an occasional series on investing for beginners. You can subscribe to get our articles emailed to you. Why not help a friend get started, too?

Note on comments: This series is for beginners, and any comments should reflect that please, rather than confuse or make irrelevant points. I will moderate hard. Thanks!

  1. Sometimes this efficiency breaks down, as behavioural economists such as Nobel Prize winner Robert Shiller have shown. But almost everyone agrees it’s big picture efficient most of the time.
  2. Yes, it goes crazy sometimes and seemingly gets it wrong – such as when we see market bubbles. Again, that’s a discussion for another day.
  3. Chosen from different sectors. They can’t all be sausage makers or umbrella factories. That’s not diversified.
  4. You might expect to do better than the market because you believe you’re a brilliant stock picker, but that’s another – very unlikely – bet altogether!

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