Last Updated on 30, March 2014
In this article, we shall examine the basic concept of risk and reward in investments and remind ourselves how risk and reward is linked. We then introduce the concept of value-at-risk. The article will conclude with practical applications for all investors.
Reward from investments
Investments have often being mistakenly to be similar as speculations. Speculation has to do with attempting to achieve high gains within a short time frame while investment has to do with achieving reasonable gain over a long term time frame. The time frame is important because it determines the risks that one can take (more on this later).
The S&P500, an index tracking the weighted average of top 500 companies in the US, shows that for all 20 years period, the returns of the index ranges from 3.1%p.a. to 17.9%p.a. – before taxes, expenses and inflation.
On the other hand, the 5 year US Treasury Bill 20 year period return range from 1.58%p.a. to 9.92%p.a.
Traditional assets like equities (stocks) and bonds should rise over on a long term basis. Returns from equities are derived from the growth of the businesses of the companies while returns from bonds are mainly from the coupons of the bonds. If we assume that most economies grow in the upward direction, both bonds and equities should rise on a long-term basis. However, focusing on the (high) reward associated with investments regardless of risks is not in the right order. Investors often chase after the hottest fund only to realize that the risk is so high that they are guaranteed to suffer a large lost.
Risk from investments
Today, equities are nose-diving. Many people are caught by surprised by the sudden shift in market direction. Most professionals such as analysts and financial advisers are now saying that the bear market is near. Yet, it was only a few weeks ago that these “professionals” were proclaiming that the bull is still on. This confuses many retail investors and as usual, most of these investors are selling out their investments due to fear. Selling when market is low (due to fear) and buying when market is high (due to greed) is the guaranteed way of losing money in an investment.
The truth is that most people ignore the most important factor in an investment – risk. In fact, the concept of investment risk is so important that it is perhaps more important then the returns itself.
Risks in investment come in two forms: Systematic risks and non-systematic risks. Systematic risks are those factors that affect the entire market. For examples, interest rate and inflation are systematic risks. Non-systematic risks are those that are associated with individual securities or a particular sector. Examples of such risks: fraud, insider-trading, mismanagement and accounting scandal.
It has been researched that there is no reward for non-systematic risks. As an example, investing in a single stock has a high non-systematic risk. In the event of fraud or mismanagement, the price of the stock could plunge or even be suspended from trading. In other words, the downside risk is so much that it could result in a very large lost. While insider trading is illegal in most countries, conventional wisdom tells us that this still occurs. Therefore, investors are always at the disadvantaged.
On the other hand, there is reward in systematic risk. The high risk due to such risk tends to produce high return on a long term basis. However, this does not mean that systematic risk guarantees corresponding high reward.
Non-systematic risks can be eliminated through diversification. Consider this: if one would to invest in 100 securities and if investment in one of the securities incurs total lost, the entire portfolio lost is only 1%. Non-systematic risk tends to occur in narrowly diversified sector. For example, technology sector tends to be influenced by the few very large and influential companies.
Non-systematic risk can also occur at the government-level. Investing in one country contains risk associated with the political stability of that country. Any political instability has a significant influence on the performance of the investments in those countries. Again, such risk can be reduced or eliminated by diversifying investments in many countries. Many Singapore residents have significant stock investments in Singapore. This is unwise due to single country risk and the fact that their livelihood is in Singapore. Any negative economical influence may affect both Singapore investments and their livelihood. Much has been said about equities. How about bonds? There are two schools of thoughts with regard to bonds. One school of though considers bonds to provide a safety asset for one’s portfolio. Due to the “flight to safety” effect, bonds tend to do well in times of crisis. However, this is only applicable for investment grade sovereign bonds. Emerging market bonds, being unsafe by definition, cannot provide that safety asset and may in fact plunge during crisis period. In the other school of thought, bonds are meant to provide for low correlation diversifier. In Modern Portfolio Theory, two securities that have low correlation but similar returns tend to provide same combine return at a lower risk. Emerging market bonds are included into one’s portfolio for the sake of diversification.
Introducing the concept of value-at-risk
Most people are not averse to profits. In fact, any investments that promise a profit – regardless of how much – is always attractive. Yet, everyone is averse to losses. It is only to what extend one is averse to losses. As a result, most people claims to be an aggressive investor during market bull but turns out to be risk-averse during market downturn. The lack of understanding of such asymmetrical risk appetite explains why people tend to buy more during market upturn and sell even more during market downturn. It also does not help that most advisers and bankers fail to understand that such asymmetric concept of risk. To provide for a parameter to measure the potential losses of one’s portfolio under worst case scenario, we introduce the concept of value-at-risk.
In economics and finance, value at risk (VaR) is a measure (a number) saying how the market value of an asset or of a portfolio of assets is likely to decrease over a certain time period under usual conditions. It is typically used by security houses and investment banks to measure the market risk of their asset portfolios (market value at risk). The VaR is seen to be how “risky” an investment portfolio is. A 20 day VaR of -14% at 99% confidence level means that in the worst case scenario under usual market conditions, an investment portfolio return is -14%. There is, however, a 1% probability that the worst case return could be worst then -14%. The key is “usual market” conditions. The value-at-risk does not take into account of unusual market conditions such as terrorism or bird-flue pandemic.
Here are the various current VaR of the common stock indices:
For example, on 12 June 2006 the Nikkei225’s VaR is currently at -16.35%. This means that the worst case return for the following 20 day period (or 1 month) is -16.35%. There is 1% that this is incorrect. The worst case return of -16.35% is NOT the expected return of the following period. Rather this value represents the pessimist’s return. In practical term, if a loss of –16.35% is difficult to swallow for the investor, it means buying into the Nikkei225 is not a suitable investment.
In the above chart, it can be seen that VaR varies for different time period. Therefore a low current VaR has to be taken into historical perspective. As an example, on 12 June 2006 the current S&P500’s VaR is -7.39%. However, when taken into historical perspective that the worst VaR was -27.19%, one must not be overly complacent with regard to the risk of S&P500.
Practical applications for investors
Do not focus on the potential reward. The potential gains and historical gains only tell half the story.
Invest only in risk that is worth taking. For example, non-systematic risks are risks not worth taking.
Diversify appropriately in different countries, sectors and assets classes. Do not put all eggs in one basket.
Be cautious against professionals who change their mind about market direction within a few weeks. They are as clueless as the man in the street.
Develop a portfolio that is suitable in terms of your risk appetite and time horizon. The portfolio’s risk should be known. Those who are not able to construct a proper portfolio should seek professional assistance.
Recognize that your risk appetite changes according to market condition. During market bull, be aware that your aggressive investing is only temporary as you will be risk averse during market downturn.
If your risk appetite changes (either due to changes in your financial situation or market condition), it is important to rebalance your portfolio according to your new circumstances. Not rebalancing it appropriately could cause unnecessary emotional and financial hardship.
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