Investment - all returns adjusted for risk the same?

mgarl10024

Hi,

This is something I've wondered about for a while.

I'm just reading The Four Pillars of Investing by William Bernstein and on pg7 he says

Two Nobel Price-winning economists, Franco Modigliani and Merton Miller, realized more than four decades ago that the aggregate cost of and return on capital, adjusted for risk, are the same, regardless of whether stocks of bonds are employed

What I'm wondering, is whether all returns are the same when adjusted for risk?

So, for example:
1) I choose a huge bucket of diversified low risk investments. The returns are low (there isn't much risk), and being low risk most of the investments survive. I get most of my original capital back, and my low return. The amount I get back in total we'll call y.
2) I choose a huge bucket of diversified high risk investments. The returns are high (there is a lot of risk), but because of this, many of the investments fail and I lose my money - however the ones that survive reward me handsomely. I get back some of my original capital, and my returns. The amount I get back in total we'll call z.

Numeric example:
1) Low risk shares cost £1. I buy 10 (covering the whole market - well diversified). 2 fail, so I only get £8 back. But the ones that survive give me £1 return. I therefore have £16 (£8 original, and £8 return). This is y.
2) High risk shares cost £1. I buy 10 (covering the whole market - well diversified). 8 fail, so I only get £2 back. But the ones that survive give me £7 return. I therefore have £16 (£2 original, and £14 return). This is z.

My question is, for suitably diversified buckets, is y and z the same?
So, if choosing between very large and diversified funds, does it really matter whether I choose the riskier funds or not, if the return is the same after risk is taken into account?

Thanks,

redbuzzard

Conceptually yes - the extra income offsets the risk of not being paid what you are due.

But like nearly every other simple theory related to investment, that depends on perfect markets, that do not exist. I'd suggest they are even less perfect where high risk investments are concerned, because risk itself is difficult to quantify. Then there is the emotional component of investment decisions. Humans are very poor at judging probability intuitively (if that weren't the case, hardly anybody would buy a ticket in the National Lottery - it is for all practical purposes impossible to win the jackpot).

There's also the "fraud" factor. I suspect many investments that most of us would characterise as high risk from a purely business point of view are also headed by people who have set them up in such a way that they will make money regardless of whether the investors do.

As applied to fund choices:

The risk we are more familiar with is really about volatility, which I don't think is the same thing, although the terms are often used interchangeably.

If you look at the long term returns on equity funds ("higher risk" than cautious-managed mixed asset funds) you will usually find that the returns are significantly higher long term, but there will have been some very bad times to have bought or sold along the way.

Also look up "survivorship bias" - the failures of the past may not be around so won't feature in this kind of analysis.

Linton

In theory riskier investments should in the long term provide at least a slightly better return than more cautious ones. Otherwise people wouldnt invest in them and their price would fall until they were seem to be worthwhile. You can see this working in practice if get trustnet to sort every fund by 10 year returns (the longest period where data is available). Look at what funds are top of the list.

There are many types of risk with investing but two are most relevant here. One is that the investment goes bust and you lose everything. The other is volatility. Here there may be very large gains and falls but the long term trend is upwards. So the risk is that you get frightened and sell at a loss or the value is down when you need to sell.

You can see the effect of the bust risk with bonds. The return is directly related to the perceived chance of the issuer going bust. So gilts give a very low return and junk bonds a high one. The best protection against this type of risk is diversification - for example hold lots of different junk bonds. Some will go bust but many wont. With luck and judgement the winners outweigh the losers especially if you bought during economically difficult times when many investors were frightened off.

With equity funds the situation is different. The chance of any fund going bust is effectively zero unless you start looking at something pretty small and obscure. However the price will rise and fall, sometimes significantly, with economic conditions. A skilled investor can use this to their advantage by holding different types of volatile investments and rebalancing by selling one when the price is high and buying another which is currently cheap the price of another is high.

Also high volatility has the advantage that you can never lose more than your initial stake, but the upside is unlimited.

So the answer, as is often the case with investing, is that you need to balance. If your investing is serious dont go 100% cautious, and dont go 100% high risk. Identifying the appropriate balance for your needs and personality is one of the skills of investing.

mgarl10024

I realise this is an old thread of mine, but I thought I had replied to thank redbuzzard and Linton for their excellent responses and realised I hadn't - so thank you both and apologies for the delay.

Appears to me that I was thinking "risk = risk of investment going bust", but that there are really many types of risk and I was failing to make that distinction.

Thanks again.

Al.

A lot depends - are you in accumulation or decumulation? A fund is a dumb instrument, it can be two things to two different people.

kidmugsy

It's sometimes said that diversification is the only "free lunch" in investing. Diversifying can give you what you may reasonably hope is the same return at lower risk. Some point out that reducing charges and avoiding taxes may be other "free lunches". Treasure a cheap-to-run ISA therefore.

N1AK

mgarl10024 wrote: »

What I'm wondering, is whether all returns are the same when adjusted for risk?

In short: No.

There's some very good analysis in your early responses, but the proposition can be dispelled on a simpler basis.

People value avoiding risk, or accepting risk, differently. There is almost certainly no level of risk acceptance that when applied would make all investment returns the same.

It's a bit like asking if all cars are equally good value for money; They aren't all the same for any one individual, though maybe you could take the view that all successful cars are equally valuable in the eyes of society as a whole (though I'm not sure I'd back that view).