Investing Risk and Reward
Evaluating Risk/Reward Propositions
No guts, no glory! High risk, high reward; low risk, low reward. These clichés are true, but when it comes to investing risk and reward, there’s more to unpack from these sayings.
One needs to have the courage to take risk, but to do so in an undisciplined fashion will not lead to glory, but to ruin when it comes to your money. Could someone pull the lever on a slot machine and hit the jackpot? Sure. But should they do that for 8 hours a day over 30 years? No, the casino will wipe them out.
When I was in college, one of the most basic principles I learned in Finance class was that you needed to take more risk to earn a higher return. The chart below is probably in every traditional finance book you’ll see.
Exhibit 1
Source: Howard Marks, Oak Tree Capital
In reality, Howard Marks says risk a should look like the chart below, with Company A being lower priced than Company D. Note how the bell curves show that when you take higher risk, you’ll encounter a wider range of possible outcomes (from very favorable at the top to very unfavorable at the bottom). The traditional risk/return graph (Exhibit 1) is not fully accurate, because it only portrays the midpoint on the bell curve and not the full range. In other words, when using a higher risk strategy, investors need to understand that they could lose a lot of money, make a lot of money or anywhere in between.
Exhibit 2
Source: Howard Marks, Oak Tree Capital
A skilled investor tries to find asymmetric outcomes. In plain English, that’s means a good investor only makes a bet if the odds are in his/her favor. In the book “The Dhando Investor” by Mohnish Pabrai, he calls this “heads I win, tails I don’t lose much.”
At WealthArch, to stack the odds in our favor we analyze the value of companies to determine their fair market share price, and only invest in them when they provide a margin of safety. In other words, we only invest when there is a big enough price buffer to absorb potential losses. This way of investing allows us to stack the odds in our favor. We talk more about value investing and margins of safety here and here.
As a result of our investment approach and analysis, and if we execute correctly, our risk/return graph looks more like this (upside is asymmetrically higher than downside):
Exhibit 3
Source: Howard Marks, Oak Tree Capital
Over time, because the stock market swings wildly between extreme greed and extreme fear, we tend to be contrarian and gravitate towards point A when most stock prices are high, and D when they are low.
But let me take the above concept one step further. During a non-extreme period, even when stocks are going up, we would prefer investment A in Exhibit 3 rather than investment D in Exhibit 2, because everything in Exhibit 2 has a normal distribution (beta). All investments in Exhibit 2 do not give you any “alpha” or “edge”, so we don’t want to invest in anything that offers zero advantage risk/reward propositions like in Exhibit 2. This is why we don’t invest in index funds since they offer no alpha potential.
To illustrate this concept in an opposite scenario, when the stock market is falling significantly, we would prefer investment D in Exhibit 3 (higher reward with less than normal risk where there is alpha) rather than investment A in Exhibit 2 (less reward with normal risk where there is no alpha).
In case that still sounds Greek to you, let me give a more concrete example. Someone offered you 2 bets with a coin flip.
Bet 1- you win $100 if the coin lands heads but lose $100 if the coin lands tails (no alpha). Bet 2 – you win $200 if the coin lands heads but lose $190 if the coin lands tails (has alpha).
Which one would you take? The answer is clear: bet 2 is much better than bet 1, even though you have to bet a higher amount.
Ultimately, we have no preference between A, B, C and D in Exhibit 3, because investments that provide alpha are usually hard to find (unless everyone is panicking). Whatever the macroeconomic backdrop, we just try to find good investment opportunities that tilt in our favor.
If one stock earned 10% per year compared to another stock that earned 8% per year, but the first stock had double the risk of the first, we believe that the second stock is the better investment from a risk/reward perspective.
We view investment managers the same way. Many things could happen over the long run, so we don’t invest in ETFs or mutual funds that have the highest returns. Instead, we invest in the ones that have the best risk-adjusted returns. We think you should too.
Please let me know if you have any questions or comments.
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Earl Yaokasin, CFA, is an investment manager who runs WealthArch Investment Services in Pasadena, CA. He is a fiduciary with over twenty years of experience, and whose entire personal portfolio is managed by the firm in the same investments as the company’s clients. His firm focuses on value investing, similar to Warren Buffet’s successful approach, and disciplined strategies designed to create growth with downside protection, enabling clients to move steadily towards their life goals and aspirations with confidence.