Risk and Return: A High-Maintenance Relationship

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“Every successful business is evidence of a previous act of courage.” So says Peter Drucker, one of the great management gurus of all time. In his view, success happens because someone took a risk – and it paid off.

We all encounter various risks throughout our lives. Some of us embrace them, and some of us reject them. The former are often thrill-seekers, addicted to an adrenaline rush; the latter are usually timid souls who view risk as unnecessary peril.

The middle-ground view – which in my opinion is the most intelligent response – is to accept risk, but try to reduce (or even eliminate) it whenever possible. But it isn’t always possible: many times risk is a necessary part of success. In order to create opportunity, I believe that investors should actively seek out risk.

When it comes to investments, there’s a proven relationship between risk and return. But like most intimate relationships, this one can be complicated by a number of factors.

One is “risk-aversion.” Many investors got burned taking risks at one point, and now feel the activity is a mug’s game. They keep all their money in low- yielding guaranteed investments, just because these present little risk.

Mostly, these investors have the right idea. Dalbar, a Boston research firm, surveyed the market and concluded that the average equity mutual fund investor earns less than Treasury Bills over time. This might seem puzzling, since the market usually returns three times what T-bills do.

But I can explain this apparent contradiction. Firstly, not all risks are worthwhile ones. Some are just plain ill-advised. You might open a beachwear store at the North Pole, for example, but not be rewarded for it. Or you could put your life savings into a couple of stocks, and get burned. The Dalbar study blames attempts at market timing for the struggles of the mutual fund investors. Most cash in-flows to equity funds occur at market peaks, and most out-flows come at market bottoms.

One of the tenets of modern portfolio theory is that you won’t get paid for risks that can be diversified away. This doesn’t mean that an undiversified portfolio is always a bad idea; it just means that you have to rely on something besides market-risk premium to make money.

So what can you do to ensure that YOU don’t join the crowd of unsuccessful market participants? My advice: first think about why you’re willing to accept risk in the first place. Then, be clear on just what risks you’re taking, and which of them you’re likely to get paid for.

Why is risk a good thing? Mostly because people need a high rate of return on their portfolios. Inflation takes away half your money every 20 years, and taxes take the other half – if all you do is just earn interest. So if you want to keep drinking decent wine, you really need some type of high-growth asset, such as real estate or stocks. And those assets are inherently risky.

When it comes to which risks to take, three principles guide my own recommendations:

1) Reliable evidence says that most professional portfolio managers don’t beat the market in the long run. So don’t worry about beating the market, worry about making sure you are getting market returns.

2) You don’t get reliably paid for taking risks that can be diversified away.

3) Nobody knows where the market is going in the short term – think long term. And for stocks, a reliable time period is ten years or more.

Based on these three principles, I think “intelligent risk” consists of having a portfolio that contains hundreds of stocks (if not thousands). Combine that with giving up the bad habit of “timing” markets, and only putting your money into stocks if you can leave that money alone for at least ten years.

Of course, that’s not to say you can’t also choose other strategies: Find a hot stock and load up on it. Get in on the ground floor, when the time is right. Put your faith in the portfolio manager with the lucky streak. But if those are your preferred strategies, I wish you lots of luck – you’ll need it.

Alan MacDonald, an investment advisor with Richardson GMP Limited, helps investors with over $500,000 of assets make smart decisions about money. Alan is the co-author of “The Copperjar System, Your Blueprint for Financial Fitness” available on Amazon.

For more information please visit www.alanmacdonald.ca or email Alan at Alan.Macdonald@RichardsonGMP.com.

All material has been prepared by Alan MacDonald, Investment Advisor at Richardson GMP Limited. The opinions expressed in this article are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP or its affiliates.

Richardson GMP Limited, Member Canadian Investor Protection Fund. Richardson is a trade-mark of James Richardson & Sons, Limited. GMP is a registered trade-mark of GMP Securities L.P. Both used under license by Richardson GMP Limited.

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