Risk & Return – A Match Made in Finance

Posted by: Athelon Wealth Management | Posted on: September 30th, 2011 | 0 Comments

When considering an investment opportunity, investors typically rely on a single number in making investment decisions: the nominal return of an investment. The nominal return is the amount quoted in statements such as “this investment can show you 15% annual returns” or “this product pays a 10% fixed annual rate”.

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The 15% and the 10% figures are known as the “upside potential” of an investment. When presented with an attractive number such as 15%, it is easy to forget that there is also a “downside” component associated with every investment. This downside potential is the risk that you are taking on in exchange for those returns. When we consider both the upside potential (the reward you are seeking) together with the downside potential (the risk you need to take on) we can then arrive at a very important figure: the risk-adjusted return.

In a perfect world, high returns such as 15% would be available completely risk-free. That is, your upside potential would be 15% while your downside potential is 0%. In this case, the risk-adjusted return is 15% – very attractive!

In reality, however, nothing is risk-free, and we must take on at least some risk to enjoy higher returns. So let’s say that for the 15% return referenced above, we estimate that the downside potential is 10%. This means that if we invest $100, we are hoping to make $15 after one year while being prepared to lose $10 in exchange for those potential gains. In this case, the risk-adjusted return is only 5% (15%-10%). We can see now that when considering the risk aspect of the equation, the exact same opportunity for gains is suddenly much less attractive than it originally appeared.

It should be noted that risk-adjusted returns are not an indicator of the specific return that you can expect to receive on a particular investment. That is, a 5% risk adjusted return does not mean you can expect to earn 5%. Instead, risk-adjusted returns provide a method of comparing different investment options to find the one most suitable to your needs and goals.

To illustrate this point, let’s consider two investments side by side: Investments A and B. If Investment A promises 15% returns with a 20% downside, and Investment B is offering 10% with an 8% downside, we can determine that the risk-adjusted returns are -5% for Investment A and 2% for Investment B. When risk is considered, Investment B may be the better choice, even though its nominal quoted return is lower.

Although considering the risk-adjusted return is a simple and quick method to determine whether an investment is right for you, this is where many investors can get themselves into trouble. The reason is that when presented with a seemingly attractive investment opportunity, people often forget to consider why a particular return is being offered.

Just as with anything else in life, higher returns come at a higher cost, and that cost is risk. Risk can come in the form of volatility, which is the tendency for the price of a security to fluctuate over time. Risk may also be based on the financial health of a company, as entities which are at risk of becoming insolvent must pay higher rates to borrow money. In addition, risk can stem from the inflexibility or illiquidity of an investment, or other factors. Fundamentally, higher returns are in most cases an indicator of a risky investment because the issuer is paying investors more for the use of their funds.

So while 15% may be the quoted return for a particular security, the reason for such a high rate may be that issuing company is having financial difficulties or may even be on the verge of bankruptcy (whether the investor is aware of this or not). Another explanation may be the particular security involves an investment in a country with lax governmental oversight and disclosure requirements. In such scenarios, the risk, or downside potential, might be as high as 50%. This means that there is a high likelihood that you could lose 50% or more of your entire investment. In this situation, the risk-adjusted return would be -35% (15%-50%).

While a 50% downside potential is definitely undesirable, it can get even worse when the downside potential is unknown. Some investments, such as hedge funds, private equity funds, OTC (over the counter) securities, and private companies in general are not subject to the same scrutiny and strict oversight as publicly-traded entities. As a result, the process of estimating the downside potential can be very difficult and in some cases, impossible. This becomes even more convoluted as the complexity, volume, and variety of transactions and security types within the financial markets keeps gradually increasing.

So if we consider, for example, 15% upside with an unknown downside, we may end up putting money into a security with a hidden 50%, 60%, 80%, or even 100% downside potential. If we don’t know the downside risk, it is impossible to calculate the risk-adjusted return. As a result, a modest market downturn could have a potentially significant impact on a client’s overall portfolio.

The reality is that in many cases, the upside and downside potential may be very closely related. This means that a 15% potential upside is often accompanied by a respective 15% downside. This is also the case with promised returns of 30%, 40%, or higher – the greater the return, the greater the potential downside.

This relationship between risk and reward is often not clearly explained to investors looking for high returns. In some cases it may also be misrepresented. The result is that many investors may be risking much more money than they are financially or emotionally capable of losing. Additionally, investors may not be adequately compensated for the risks that they are taking.

Even though an investment with a greater upside generally carries with it a greater downside, it is not necessary to actually reach that downside. Instead, it is often beneficial to set a predetermined threshold which will dictate the maximum loss that you are willing and able to tolerate. So, for example, if you choose investment with a 40% upside, you may decide that you are only willing to take a maximum 10% loss in pursuit of those gains. This is where active portfolio monitoring and an objective, non-emotional approach can be very helpful in maximizing your returns while reducing risk.

This is just one of the benefits we provide at Athelon Wealth Management. As an Independent Fee-Only Registered Investment Adviser based in Staten Island, New York, we help our clients reach their financial goals while protecting them from excessive and often unnecessary downside risks. To accomplish this, our process involves creating highly customized portfolios to obtain the desired level of return while effectively managing risk through diversification, ongoing in-depth research, and periodic portfolio rebalancing. In choosing investments for our clients, our methodology emphasizes transparency, liquidity, and value. This helps to ensure that each portfolio is working most efficiently and increases the chances of reaching the financial goals of our clients.

Give us a call today at (347) 706-1414 for a FREE introductory consultation. You may also visit our website at athelonwealth.com for more information.

Please note that there are many other factors involved in assessing the potential risks and returns associated with any investment. In fact, entire MBA courses may be devoted entirely to this single topic. As such, this article is meant to serve only as a basic introduction to risk management, and is by no means a comprehensive listing of the factors required to make an educated investment decision.

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