[This Commentary originally appeared in the September 14, 1989 issue of The Mendon-Honeoye Falls-Lima Sentinel.]
Part One – The Risk-Return Tradeoff
The following is the first in series of two commentaries aimed at presenting a unique approach to determining our nation’s position within the world’s economy. This week is expository, meaning some readers will already be familiar with the concept of the risk-return tradeoff. In the spirit of all mini-series, we save the real interesting part for next week.
Finance professors, like all other professors, find they can enhance their employment options (i.e., get tenured) by coming up with all these fancy dancy theories to describe the real world. They write scholarly articles and intricate textbooks (most of which end up on the “Required Reading” list of the courses they teach). Many of these theories remain in the academic realm (where they can take on a life of their own). Every once in a while, though, a really neat idea escapes the verbosity of pedantic journals and appears in the vernacular of the newsweeklies. (When this happens, the professor generally writes a book for the casual reader, appears on several talk shows and becomes a highly paid consultant.)
One of the more significant investment models developed by the academic industry goes by the name, in generic terms, Modern Portfolio Theory. It attempts to provide a theoretical basis for why people invest in the various things they invest in. The theory is not causal. In its most pure form, it does not try to predict an outcome in the manner of a physics theory (although financial alchemists often try to make it do such a thing).
The notions of risk and return represent the fundamental elements of Modern Portfolio Theory. Of the two, the average person understands the latter a lot better. The return represents the amount of money made (or lost) on a particular investment (not including what you originally paid for the investment).
Let’s look at an example. Suppose you opened up a savings account by putting $100 in it. After exactly one year, you close the account and the bank gives you $106 back. Your return is $6 (since we don’t include the original $100 used to open the account). In this case, because we had the bank account for exactly one year, we calculate the annual rate of return by dividing the original investment ($100) into the return ($6) to come up with 6%.
To pound home the thought, we’ll try one more example. Say we bought 100 shares of XYZ Corp. for $10 a share and sold the stock one year later for $8 a share. We would have paid $1,000 for the stock and received $800 when we sold it. Our return would be -$200 (i.e., we lost $200 on the investment) with an annual rate of return of -20%.
Pretty straight forward stuff compared to how we will define risk. In strict theoretical terms, Modern Portfolio Theory suggests the risk associated with an investment depends on the volatility of returns. Wow. A mouthful.
Said another way, let’s take two investments – your savings account and XYZ Corp. stock. Since the bank promises to pay you a certain amount (in this case, 6%), you are nearly certain to get that return on your money (and if your savings account is less than $100,000, the U.S. Government, through the FDIC, will guarantee that you get that money). XYZ Corp. stock, on the other hand, makes no guarantees. (It doesn’t even have to pay a dividend if it doesn’t want to.) We therefore have a wide variety of possible returns. The annual rate of return of XYZ Corp. can range from -100% (you lose all your money) to infinity (you make loads of money).
Risk measures how certain an investor is of getting a return. The investor can depend on the bank paying interest in the money in the savings account. The investor cannot, with equal certainty, predict the return of XYZ Corp. Therefore, XYZ Corp. stock is riskier than a savings account. In fact, because the investor is virtually guaranteed to get the return on the money placed in the savings account, we might be tempted to call this a riskless investment.
Now, despite our example, one should not conclude the wisest thing to do is to always keep one’s money safely stashed in a savings account. The terms safe and risk are linked – something which is less risky is said to be safer. (Please remember this for next week.)
Recall the savings account will only yield an annual return of 6%. XYZ Corp., on the other hand, can produce a return much more than this. In order to decide what to invest in, says Modern Portfolio Theory, one must consider both the risk and the return associated with the particular investment.
The risk-return tradeoff, simply stated, implies one will expect a greater return from a riskier asset. For example, would you pay more for an old lotto ticket which has already won $100 or a new lotto ticket which only has a 50% chance of winning $100? In the purely mathematical world of game theory, you would pay no more than $100 for the winning ticket and no more than $50 for the risky ticket. (The $50 is determined by calculating the average of the two possible – and equally like – returns, namely $0 and $100, the average of which being $50.) If both tickets are winners, you get back 100% of your investment on the “sure thing” ticket, but the return for the risky ticket is 200% of your investment.
More risk, more return. The price you pay for an investment is directly related to the return you expect that asset to yield. Please note the above does not imply higher absolute prices always mean lower risk. The price we refer to is the relative price. For example, to change the lottery example a bit, suppose the old lotto ticket only won $25, but you still have a 50% chance of winning $100 on the new ticket. You would therefore pay at most $25 for the riskless ticket (it’s riskless because it’s already won the $25) and still no more than $50 for the risky ticket. In this case, the safer ticket costs less in absolute terms than the riskier ticket.
For the investor, less risk means less expected return. Savings accounts rarely outperform, say, the best start-up company stocks. Of course, on the flip side, a savings account would almost never underperform the worst start-up computer company stocks (which all tend to lose money). So, according to the theory, whether or not you invest in savings accounts or computer stocks depends on how much volatility you can stomach.
[What is this and why is here? See Interested in Discovering My Time Machine? for more details.]