How do investors prepare for the potential damage that risk can bring?

We often hear the saying, “High risk, high reward.” The idea is that only by taking on more risk can we achieve significant returns. But is that really true? The answer is both “yes” and “no.”

It depends on your “perspective”.

The relationship between risk and reward is like this: while high risk can sometimes bring high rewards, low risk can also deliver high returns. It’s like the old fable of the tortoise and the hare – in the investment world, those who are cautious, patient, and persistent often outpace the overconfident hares and reach the finish line.

My perspective has evolved to a higher level, encouraging a long-term view of investment strategy.

Basically, all types of investments and assets, like bonds, stocks, or real estate, can have their risk quantified through the volatility of their returns. By comparing these, we can determine which ones are more volatile (risky) or stable.

The author analysed closing price data from January 1926 to December 2016 – over 80 years – and from 1929 started “constructing” two portfolios, each with 100 stocks: one “high volatility” and one “low volatility” portfolio. The results showed that the “low volatility” portfolio outperformed, with an annualized return of 10.2% over the past 88 years, compared to 6.3% for the “high volatility” portfolio.

The key is time.

As mentioned earlier, the contradiction between “high risk, high reward” and “low risk, high reward” depends on your perspective. What’s the crucial difference? The answer is time.

A 3.9% difference per year might not seem like much, but thanks to the power of compounding, it has a significant impact over time. So, if we aim for long-term investment, we can see that the tortoise’s steady, persistent pace is more likely to achieve the goal than the hare’s sporadic bursts of speed and laziness.

Change your perspective.

If long-term investing can achieve low-risk, high-reward goals, what causes different perspectives? It boils down to your role in the investment world – are you an investor or a fund manager? Investors focus on absolute returns, while fund managers focus on relative returns, leading to different investment decision-making processes.

Absolute returns involve evaluating the value of an asset and aiming to balance the risk-reward ratio of the portfolio, using strategies to achieve the highest and most stable returns. But many institutions or fund managers don’t think this way. They’re more concerned with how their portfolio performs relative to the market. Beating the benchmark is their priority, not necessarily the absolute value of the returns.

This leads to several additional issues. When everyone focuses on relative returns, there’s more emphasis on short-term performance. The annual, or even quarterly, results are closely tied to their careers. Maintaining performance close to peers or the benchmark is considered safe, which can limit their vision and potentially make them more short-sighted. Ultimately, the investors suffer. This vicious cycle created by industry and investor mindsets requires mutual effort to change, as evidenced by the growth of index investing.

I used to believe in the saying “high risk, high reward.” It seems logical that to earn more, you need to take on more risk or effort. On a trading level, this holds true. But experience trumps theory, and data trumps experience. Through accumulated experience, changes in portfolio values, and adjustments in investment mindset, you naturally realize that low risk and high returns are achievable.

Pedro Hill - The Tortoise vs. the Hare