The Investor’s Risk/Return Tradeoff
What the poker player is doing in those long interminable periods of thinking is essentially considering his return on investment. What is specifically calculated in the poker player’s mind, in addition to what he/she believes, based on available information, to be the odds of winning the pot, is the payback. In other words, if the poker player is holding a hand with a one-third chance of winning, he/she must consider whether it’s worth supplementing the pot to the tune of forty percent. Yes, higher risks can equal higher returns, but the fact that the same few players are usually sitting at the final table in the World Series of Poker shows that the high jackpot-like returns must be supported by slow and steady gains.
In investing, essentially two major mistakes can be made, each involving the ignoring of the other side of the coin. Either the investor sees the possibility of huge returns and mentally bypasses the strong possibility of failure due to risk, or the investor squanders opportunity after opportunity and disregards opportunities to take even the slightest risk. The first gaffe results in losses of the original investment rather more quickly, while the second produces losses based on taxes and inflation alone.
A classic example of the latter can be provided by the U.S. Treasury bond investment. Considered to be one of the very safest investments anywhere in the world, an unfavorable tax scheme and/or a period of high inflation can actually cause a negative gain, even on a bond that is allowed to mature. Should the bond be redeemed before the maturation date, the investor is totally at the mercy of U.S. interest rates.
In contrast, stock market returns almost always outdo inflation and tax rates. But where there are winners, there also must be losers. The reality of risk rules over stock market investment, and few stocks do not prey to the whims of complex world markets. The stock exchange can give higher returns, but higher returns always equal higher risk. An easy answer to the problems inherent within stock investment is diversification, and therefore mutual funds were followed by index funds which were followed by ETFs. These funds incorporating a great deal of the market to reflect the growing economy are safer than traditional stock market investment, with levels of financial security increasing through the three generations. Index funds, thought to be a relatively extremely safe investments can also drop in value quickly, though this is rare. The record drop seen in the Standard & Poor’s 500 since the inception of index funds resulted in a forty percent decrease in value within one quarter. In such a market situation, ETFs would have taken a small loss spread over a slightly longer period of time.
Why does the poker player only ante half a given pot rather than forty or sixty percent? For the same reason risk and return in investment must be thoroughly researched before entering the market: Potential returns on investment must be capable of compensating to the level of risk.
In modern investment theory, the key measurement is volatility, a principle closely related to risk. Volatility measures, via standard deviation calculation, the potential swings from the norm a given investment is likely to make. Some have taken issue with the dependence of the Sharpe’s capital asset pricing model on this volatility measurement.
Volatility, goes the argument, runs both ways. A volatile trend upward is self-evidently not at all negative for the investor, and all that is necessary to fear is downward volatility. The problem with investment tactics using the formulae involved in the capital asset pricing model is that, in times of declining market, modern portfolio theory calculations can work against the investor by not reacting to sudden increases while forced to deal with rapid decreases.
However, exchange traded funds do provide a solution to this problem as well. Since ETFs can be traded on an intraday basis, the ultra-conservative investor can still pull all of his or her ETF investment before the damage is more than minimal. Deliberate disregarding of the market altogether would be required before an ETF investment takes anything resembling a serious hit (see above, with index funds losing forty percent in the most extreme of situations over a period of months.
With the sphere of investment risk itself are different sorts of risk. The first is inflation. Times of heavy inflation can wound the most serious of investments, but this phenomenon can usually be waited out; periods of inflation in western markets can hardly outlast a long-term fund, and no such extreme timeframe has occurred since the inception of ETFs.
“Industry risk” refers to uncertainty in the market due to an industry-wide shakeup. Political risk is usually not considered by those with small- or mid-sized investment (though this is being factored in more and more often as crossovers between international markets become more and more commonplace in ETFs and index funds), but political changes even in that most stable of democracies, the United States, can affect industry. With the parameters of federal funding for T-cell research, aerospace exploration and the military-industrial complex possibly seeing change in the next general election, for example, these industries (and the investors in them) are certain to see shakeups of some kind.
In any sort of currency trading, the realm of currency risk is opened up, representing another entire dimension of complexity and random factors into the mix. The new exchange traded funds based on the Euro remain appealing, though, for both short-term (this currency has seen excellent gains for some time against the dollar and yen) and long-term (the upward trend sees no sign of decrease and could very well increase once the currency is introduced in the new Central/Eastern European member states). Indeed, the Euro may represent an exception to the currency risk, as with increased investment and increased use can come increased value; certainly, increased stability and predictably are in at least the medium-term future of the Euro.
Liquidity risk is the last major source of risk and refers to the inability to sell. Proponents of exchange traded funds can argue here that, technically, ETFs aren’t really sold per se. No actual cash is involved in ETF transactions, and a securities portfolio of shares in like ratio to the creation unit is exchanged with the seller at the point of sale. This essentially means that the exchange traded fund can be exchanged for more fluid stocks more representative of individual firms traded successfully. In the end, liquidity risk is brought to a minimum.
Modern portfolio theory is centered on taking literally calculated risks in investing to augment the stable aspects of the investor’s portfolio.
