Saturday, December 26, 2009

Investor's Myth: 'Higher the risk, higher the return'

I had a party at my place during the holidays and the men starting talking about investments they have been making. One of the guests started describing his success with speculative investments in the currency market and ended by saying: "The higher the risk you take, the higher the return". This is one of the most often repeated maxim (and I am about to argue it to be a false) in finance, but having read "How to win friends and influence people", I played the friendly host by avoiding an argument and politely changing the topic to the appetizing food at the party.

But I can make my case on my blog (that has very few readers and hopefully not the ones that came to the party). The notion of risk is one of the most misunderstood concepts in finance. So, what is risk? If you went to University of Chicago (I love my Chicago MBA friends - no offense to you guys), risk is explained using the capital asset pricing model (CAPM). In the case of the equity market, this risk is quantified using a statistical concept called the beta. As an example, lets look at the stock market. By defintion, the market is considered to have a beta of 1.0, and individual stocks in the market are ranked according to how much they deviate from the market. So, higher-beta stocks are the ones that are more volatile, and are considered 'riskier', according to CAPM. According to this theory, 'riskier' (high-beta) investments should have high long-term returns. And hence the statement: 'Higher the risk, higher the return'.

However, for this theory to be true, investors have to demand higher returns from 'riskier' (high-beta) stocks. There have to be people that demand such a relationship. In practice, there aren't many people who demand such a pricing, because most participants understand that risk is not the same as volatility. There are various types of risk: business risk (possibility of detoriation of operations, profit margins etc), financial risk (catastrophe due to high leverage), valuation risk (stock priced much higher than underlying intrinsic value of the business leaving little margin of safety), liquidity risk (inability to sell the stock in the market without affecting the price), and volatility risk (market price fluctuation). Off all these risks, volatility risk is of much smaller importance to most participants in the equity market. Besides, everybody knows that past results bear little resemblance to future results. So, why should historical volatility matter much to the future of the enterprise.

Since volatility is poor measurement of risk, lets replace the word risk with business risk and re-examine the maxim: 'Higher the business risk, higher the return'. Obviously, riskier (defined as business risk) investments cannot be counted on to deliver higher returns. Because if that were the case, then there is nothing risky about the investment. The correct formulation is that in order to attract capital, riskier investments have to offer the prospect of higher return. But there is absolutely nothing to say that these prospective returns will materialize.

Often, this simple logic is forgotten. Here is what really happens: Riskier investments are priced to deliver higher returns (if the investments materialize). Such a pricing is required to start attracting capital. In some cases, these investments start paying off handsome returns. The maxim 'Higher the risk, higher the return' starts getting repeated. And, hence the investment attracts more capital and bids up the price of such investments. At some point, the pricing of these investments are bid-up to such an extent that the investor is not compensated adequately to take the risk. Warren Buffet often says: 'What the wise do in the beginning, the fools do in the end'.

Here is a specific example from the recent credit boom and bust. At the begining of 2003, credit spread for high-yield bonds (another name for junk bonds) was at historical highs of over 1000 basis points. Investors were getting paid a premium of 10% over the default risk-free US treasury bonds to take the (credit, liquidity, market) risk of investing in junk bonds. In 2005, the investors were paid a mere premium of 200 basis points.

Here is another example. Cisco's stock was priced at 77$ in its peak in 2000 and had earnings of 0.36$. So, the investor in Cisco's stock in 2000 was paying 213x for the 0.36$ of earnings it had at that time. That is the equivalent of a mere 0.46% yield. Risk-free US treasuries were yielding over 6% at this time. This is yet another example of inadequate compensation of taking the risk of investing in the Cisco stock. Investor's were so seduced with the story of the internet boom that they overbid the price of the Cisco stock to an extent were they were paid nothing to take on the risk. We all know what happened in the end. Those who invested in the stock in 2000 are still waiting to make their return and this is from a successful enterprise that makes really phenomenal products

Investments are not risky inherently but only in relation to its market prices. So, the next time someone recommends a 'risky' investment as one with higher return, the first question you want to ask yourself is whether the investment is priced appropriately to compensate you for the risk you are about to take.

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