With higher risks come higher rewards. That’s one of the most basic rules of investing.
However, it’s also one of the most misinterpreted rules.
“We hear it all the time: ‘Riskier investments produce higher returns’ and ‘If you want to make more money, take more risk,'” posits Oaktree Capital’s Howard Marks. “Both of these formulations are terrible.”
Marks believes investors deserve a more complete explanation of the risk-return relationship.
“[T]here’s another, better way to describe this relationship: ‘Investments that seem riskier have to appear likely to deliver higher returns, or else people won’t make them,'” Marks writes in new memo to clients. “This makes perfect sense. If the market is rational, the price of a seemingly risky asset will be set low enough that the reward for holding it seems adequate to compensate for the risk present. But note the word “appear.” We’re talking about investors’ opinions regarding future return, not facts. Risky investments are — by definition — far from certain to deliver on their promise of high returns.“
Marks shared a brilliant risk-return chart from his book “The Most Important Thing.” See below.
“As you move to the right, increasing the risk: the expected return increases (as with the traditional graphic), the range of possible outcomes becomes wider, and the less-good outcomes become worse.“
The straight line going from the bottom right to the upper left is how most people envision the risk-return dynamic.
However, it’s the curves and vertical lines at each point that that every investor better be comfortable with. While the point represents what is expected to happen, curve represents the range of outcomes the will actually happen.
“This is the essence of investment risk,” Marks writes. “Riskier investments are ones where the investor is less secure regarding the eventual outcome and faces the possibility of faring worse than those who stick to safer investments, and even of losing money. These investments are undertaken because the expected return is higher. But things may happen other than that which is hoped for. Some of the possibilities are superior to the expected return, but others are decidedly unattractive.”
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