Good morning! Today I welcome back Troy from The Financial Economist for a new installment of this investing series.
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Many investors think that risk and return are always related. This is one of those cliches that pretty much every adult is fond of. Talk about starting a business, or talk about investing in some non-popular investment vehicle, and there will ALWAYS be one guy who’s trying to act smart by saying “well, ya know, higher returns always mean more risk”. As if that were the secret meaning to wealth in this whole world. Ya gotta take risk to make money.
This is absolutely false. People think that since stocks have a higher potential return, the risk is inevitably much greater than bonds with their crappy yields. Bonds have a much lower return, thus the risk is much smaller.
The Russians defaulted on their debt in 1998. Literally no one thought they would do so at the time, hence the premiums (return) on Russian bonds were relatively low at the time. What ended up happening? The whole “low return = low risk” belief was blown apart because I don’t know what’s riskier than a country defaulting on its bonds (100% loss to investors in Russian bonds). As Ray Dalio says, “the unexpected happens all the time”.
But beyond that, here’s why risk and return are not always related. Believe it or not, there are low risk and high reward situations. That is when you should invest your money.
The founding belief behind how I invest and trade is mean reversion. What goes up must come down (unless this is applied to individual stocks, because individual companies can go bankrupt). The concept behind mean-reversion applies not just to the financial markets but to the ENTIRE friggin world. Everything in this world comes in cycles. We have the seasonal cycle (winter spring summer fall), the daily cycle (day, dawn, night, dusk), the age cycle (baby, child, teen, adult, old age) etc.
The stock market is also governed by the laws of cycles and mean reversion. There will always be bull markets (bullish cycles) and bear markets (bearish cycles). Why? Because when the market falls too fast (bear market), it will overshoot. Like an overextended elastic band, it will snap back (bull market) and overshoot as well. When the bull market overshoots, it will reverse towards a bear market, and the whole cycle continues.
That is why I’m a contrarian investor / trader. Based upon my trust in mean reversion, I want to be buying when everyone else is selling. I invest my money right before the mean reversion begins. That’s also why I try to “catch the falling knife” and buy at the bottom of a bear market.
Now here’s an example that totally destroys the “risk and reward are related” argument. Towards the bottom of a bear market, you know that the reward for buyers will be massive. Once the market rallies big time and is followed up by a bull market, bullish investors will make huge amounts of money.
So in this equation, the “reward is big”. In fact, it’s mouthwateringly good. But is the risk big as well?
No. Why? Because the market can’t fall much more. That’s the cornerstone of mean-reversion. Once it reaches an extreme, it will snap back very soon. In this case, the market is extremely oversold. Thus, the possibility of the market not rallying is practically zero. Sure, the market might fall for another 4 days, but within 2 weeks, it will have a massive rally. Thus, the risk for bullish investors is also practically zero. The risk is hugely limited (how much farther can a market really fall after a 50% crash?), while the reward is huge on the upside.
So what we have here is a low risk, high reward scenario.
Risk and Reward are Related if You Gamble
Of course, there are certain situations in which risk and reward are positively correlated. Why do a lot of investors believe in this? Because they think that investing is like gambling. They treat the game of investing as if it were just a matter of rolling the dice and risking your hard earned money.
In such a world, it is true that high risk equals high return. Think of the lottery. High risk (a billion to one, odds stacked against your ticket), and high return ($5 million). Think of penny stocks. Put in a few dollars, and maybe (yea, like a one in a million chance) the company will be the next Microsoft.
That being said, if you treat investing like a casino, you really shouldn’t be playing this game. All gamblers (besides the professional poker players) lose money in the end.
If you’re a serious investor who always focuses on what his risk reward ratio is, then there will be low risk coupled with high returns situations. That is when you want to put your money in the market.
What do you think? Are risk and reward related?