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.
Mean Reversion
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?
This post was featured on the Carnival of Financial Planning, Carnival of Retirement, thank you!
I would consider the market timing you describe in your first section to the gambling you describe in the second. Market timing is absolutely a risky strategy that hurts many more people than it helps. While I generally agree with the principle of mean reversion, it requires not only knowing (really, thinking) that it will happen, but being able to time when it will happen, and being able to time it both on the sell and the buy, over and over again. That is not something that people have proven to be able to do with any consistency and it’s a cycle that loses many people lots of money.
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I think risk can be reduced or offset with more knowledge of a particular subject. For example, my dad is a technical swing trader like you, finding the bottoms of specific stocks and then owning them for a few days. He’s good at it, and always makes money if you average out a week of trading.
For me, on the other hand, I would consider that high risk strategy. I don’t have the knowledge to make trading like that a low-risk option.
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This one is a little difficult as risks are going to always be involved. The good thing is the more knowledge and the better understand you have the lower the risk is. However when it comes to stocks and other things you just don’t control you may think going with a stable company is a lower risk but things happen and I am sure you can find a lot of instances where people thought they were getting into a low risk situation. Everyone always thinks the stocks will rally. Until they have 3-7 bad days and sell off.
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I think this can be looked at a few different ways. Having all your money in one stock of one company is pretty risky, but doesn’t necessarily pose any great “reward” for taking on that risk. One company can fail, but the odds of one company moving leaps and bounds ahead of the rest of the market are slim.
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I spent quite a bit of time at university calculating the ‘efficient frontier’ for risk and return. The basic concept is that all investments can be charted on a scatter plot, with one axis showing risk and the other showing return. It makes little sense to invest in an asset which provides lower return than an investment with the same level of risk but a higher return (or the same return at a higher risk). I believe that risk and return are correlated, but they aren’t always correlated the same for different investments.
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I try to use the “mean reversion” as an investing strategy (though this is the first time I’ve heard that vocabulary), but how do you know when the stock has truly bottomed out? For example, I bought Facebook when it was under $20 which has turned out great, but I bought Apple in December, around $500 (after falling from $700), and its struggling.
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Any stock carries some element of risk, so in effect you could say there is always a risk to any sort of reward with the stock market. I try to minimize my risk as much as possible by buying broad index funds. I hope it will turn out to be rewarding.
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You could avoid this whole scenario altogether by doing the smart thing and investing in a low cost Index Fund, which by the way is also founded on the principle of mean reversion.
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I used to think I could time the market and call the bottoms and the tops. It seemed to work for a bit in the 90s. Then I got slapped down in 2000-2003. I got out in 2000 after losing some money, but put my money back in after I thought we had hit bottom. Boy was I wrong. I lost a ton. I have learned from that to buy and hold low-cost passive index funds. I am more than happy with market returns, which are above average, because my costs are so low.
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Interesting. I’ve heard risk and reward are related from many different sources, but I’ve also heard different views. I think that if you’re willing to take risks, you’ll be more likely to profit off of some of those risks, but not all.
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I wouldn’t call age a cycle unless you believe in reincarnation. Otherwise, you don’t become a baby again after being an old man.
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I feel that risk and reward are related. Stocks are riskier than bonds in that in any given year, stock prices can vary wildly whereas bonds can also vary, but not nearly as much. Yes, the bond example you pointed out is a possibility, but it is an outlier.
Most people aren’t going to be able to stomach buying stocks after they fall 50% or sell after they have risen 100%. It’s not in their DNA. Their best option is to invest in a diversified portfolio that is low in fees and focus on the long-term. This post explains why: http://moneysmartguides.com/the-importance-of-focusing-on-the-long-term
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Troy!!! Marvy article! Humans suck at identifying causal relationships. That’s why we have superstition, dogmas of all kinds and the like. Serious investors have knowledge and expertise which I gather does a fine job of debunking popular thought on investing. Whether risk and reward are related is relevant to the case at hand. Love your article! Have a beauty of a Tuesday!!!
Risk and reward are related. Now, the amount of correlation may vary across different investment types, market conditions, etc. But the risk-reward relationship is very real and is a core financial concept. I think the “mean reversion” strategy you describe is a good one (essentially “buy low, sell high”). That said, the example you provide still has lots of inherent risk involved and the possible reward is related. The risk premium still has to be good enough or you’d opt for a risk free investment.
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I’ve always imagined (and been taught) that more often than not risk and reward are related. And most often than not the correlation is definitely there.
What you describe on the other hand does seem to minimize the risk out of stock trading, one problem though, how does the average person determine that the market has now tanked and its time to buy or now we are at the peak and its time to sell. The framework is wrought with tough points to be sure off and might actually increase the risk for the ordinary investor.
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A great way to becoming wealthy is to locate asymmetrical risk-reward situations and betting on sure things.
I did a post on the subject here http://wealthymatters.com/2013/04/26/bet-on-sure-things/#more-5220
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