In a previous blog, we covered different types of investments, but this time let’s talk about Risk versus Return. Risk is the range of uncertainty of gain for an investment combined the likely percentage of the investment you could lose should the investment go bad. Return is the amount of gain one receives for their investment usually represented as a percentage of the amount invested. For example, if you receive $10 on a $100 investment, this is a 10% return. However, I also like to time-weight the return because a 10% return over ten years is only a 1% return per year and a 10% return over one month suggests a more than a 100% return over the year!
To illustrate the concepts in more depth, let’s consider a few examples.
Example 1: Low Risk, Negative Return.
Assume an investment that was estimated to lose 1 to 3% each year and we were very certain (85%+) that we would receive those returns because the last 10 years had fit within this range, then we would call this a stable, low risk investment. The most stereotypical example of this type of investment is cash. Cash loses value at the rate of inflation which has varied between 0.7% and 3% over the past 9 years. Since the US dollar is tied to one of the strongest countries in the world and is a global currency of preference, there is only a tiny risk that the investment will become worthless – well, at least for the next decade, we’ll see about beyond that. In any case, the failure risk of US currency is as close as you can get to zero. Of course, since this investment is all but guaranteed to lose money in comparison to inflation, the dollars buried in my proverbial back yard must be labeled a Negative Return investment.
Example 2: Moderate Risk, Moderate Return.
3M currently has a bond maturing on 9/19/2026 that has a 2.25% coupon. In other words, it pays interest at 2.25% against the ‘$1,000’ bond. In May of 2019, this bond is trading at $956.80 or $43.20 below the ‘face’ value of $1,000 for an overall yield of 2.908%. Since the return is positive and relatively modest at ~3%, this is a Moderate Return investment. However, since 3M is a corporation, there is a chance that the company could go bankrupt and fail to repay their bond, so this carries some risk. Yet 3M is a huge company with strong financials and popular products (I love post-it notes!) so that risk is not large. For most people, corporate bonds merit a moderate risk rating even though I personally feel so strong about 3M to consider this a low risk. The return at 3% is positive, but does not set the world on fire. Some might consider this a low return, but in comparison to cash or certificates of deposit we can consider this a moderate return.
Example 3: High Risk, High Return.
Tesla is a cool stock with a charismatic founder, Elon Musk, and a very attractive product. At the time I am writing this, the stock trades at $228, but has traded as low as $224 and as high as $387 within the past 52 weeks! Very volatile. Meanwhile, the company is not consistently profitable and tends to miss their targets for sales and deliveries. There is a significant chance that Tesla could go out of business and the stock could become worthless, so between that possibility and the swinging prices, this should be considered to be a high-risk stock. However, if you had purchased at the stock at $200 in late 2016 then even at its low of $224, you have 12% more value than you started with. Over the last three years, this averages to a 3% return per year which would qualify as a moderate return. However, at $387, you had a 93.5% return which over three years would be a 31% return! That is a very high return. Therefore, as a potential investment with big upside we can consider Tesla’s stock to be a High Return, High Risk investment.
Example 4: Speculative Risk, High Return.
Sears has operated for over 100 years, but it looks like their days are numbered. After a leveraged buyout and merger with K-mart, the big-box retailer has struggled in just about every possible way. At the time I am writing this, their stock trades at $0.48, but has traded as high as $3.91 and as low as $0.12 within the past 52 weeks. This is a volatile stock and if it files bankruptcy, the stock price will quickly go to zero. With their track record, it seems like Sears stock will be worthless again within the next couple of years. With such a dark cloud, it would be Speculation to buy the stock and hope to cash in on a big upswing. Not that a big increase can’t happen – it is just really unlikely. As for the return, at $0.48, there is not so much to lose (on a per share basis, anyway), and even if the stock goes up to just $1.00 you are more than doubling your money! Speculation can be fun, but to preserve my sanity, I have to limit it to things I really believe in AND to a dollar amount I can afford to lose… For me, speculative investments tend to be more like playing the lottery than an investment.
Although these examples provide a rule of thumb, many analysts prefer a more rigorous mathematical approach for an investment would be to compare the expected return with the expected loss (reasonable worst case):
Expected Return = <Estimated % Return> x <% estimated likelihood of achieving that return>
Expected Loss = <Potential % Loss> x <% estimated likelihood of losing>
Unfortunately, no one knows the exact numbers, so you must estimate them for yourself. In our MBA finance classes, we called this process MSU: Make Shit Up. Since I am not an economist paid to believe my guesses might be correct, I’m just going to stick with my rule of thumb for investing. Next time, I’ll cover some specific investments, personal comfort zones and how some income investments can be low risk and high return!