Risk and return explained

In investing, as in life, we do not always benefit by taking risks. Not every risk in a portfolio comes with a corresponding return and this is true even if “markets are efficient.” 

We would first try to point out what the risks in our portfolios are, and secondly, the more crucial step, is to find which of those risks you are rewarded to take and which we are taking without any compensation. This is an essential step because it is not true that all risks come hand in hand with excess returns.

We will start with a stylised example and then move into more complex asset allocation issues. With Premier League football season in full swing, consider the following scenario:   

Peter does two things with his savings. One, he invests in equities, and two, every week he bets on some chosen Premier League games that the total goals scored are more than 2.5 per game. Those are his two “investments.”   

Let us try to analyse Peter’s portfolio. What are the main forces (often called “factors”) that are driving the day-to-day movements of his portfolio? We should do what we call a “factor analysis” or “factor attribution.” We would most likely see two risk factors:  

1. Equity markets, and 

2. Total goals scored in a game in the Premier League.

   
   

Those are the two main “risk factors” in Peter’s portfolio. In other words, if you could ask any two questions about the world to get a handle on how Peter’s portfolio is doing, you would ask “how are equity markets doing?” and “how many goals are Premier League teams scoring in a game of football?”  

We have successfully mapped the risks in Peter’s portfolio, which is the easy part. “Which of those risks is Peter getting compensated to take?” In other words: which of those risks carries a positive return premium? We would find that equities carry a positive return premium (described in more detail below), but betting on goals scoring in Premier League does not. The latter is uncompensated risk in Peter’s portfolio (unless he has predictive alpha in this area, meaning he can systematically out-predict the market, but let us assume he does not). This is true even if the betting market perfectly prices his bets, and there was no margin added by bookies. To win in betting, he would need to be better at originating these bets than the market, to have predictive powers better than the whole market.

It is obvious that Peter is taking uncompensated risk in betting on how many goals are scored in Premier League games, however this is a good example for actual dilemmas investors face when it comes to asset allocation decisions. If we replace betting with commodities, things become trickier. 

Some investors have a commodity allocation in their portfolios, an intentional allocation, so those investors believe that taking on commodity risk brings a return premium. But is it true?

The best starting point is to assume that a risk factor does not have a return premium, unless there is a strong reason it has. Let us go back to the above example:

1. Equity Risk:  Equities have strong theoretical support for carrying a positive return premium, equities would not exist unless they had one. When businesses issue stocks, they want cash in exchange. From the investors’ point of view, equities are a pure investment product as there is no real reason for anybody to buy equities, to give businesses that cash, unless the businesses price for those shares return more than the risk-free rate. As a result, equities by virtue of their existence as pure investment products and highly likely to bear a positive expected return. Incidentally, the same goes for corporate bonds. Nobody is taking on credit (or term) risk without being compensated for it. If markets are efficient to any degree at all, both equities and bonds have positive return premium. One thing to mention here, the availability of money and credit due to Central Banks interventions could affect the risk premium for bonds, especially for Government bonds, but as a result it affects the risk premium for corporate bonds and even equities.

   
   

2. Betting on number of goals in Premier League: there should be no return premium associated with betting. There is nobody that needs to “sell” this risk to investors in the way that companies need to sell equity. There is also no correlation between total number of goals scored and the broader economy, so betters are not likely to shy away from betting for fear that they will crash while they could lose their jobs in a recession, which is an important concern with equities. There is no academic or empirical evidence analysis that would show  betting on the number of Premier goals in a game pays well over time, so assigning “zero premium” to betting risk factor is probably a good starting idea. 

   
   

3. Short Equity Risk: Before moving to commodities let us take a short look at short equity risk. Going short the equity market is risky; an investor could lose more than the money he invested. If we believe going long on equities has a positive return premium, then going short on equities must have a negative return premium. This is an intuitive example of a risk that the market over the long term does not reward. Sometimes investors take short risk for the possibility of short-term gain, but it is, for good reason, not commonly part of long-term asset allocation. However, a combination of long and short equity risk could have a positive return and has a lower systematic (market) risk, however it adds other risks.

   
   

4. Commodities Risk: Commodities are different than equities, as they are not pure investment products, and they do not exist solely to generate returns for their investors. In fact, finance professionals might be interested to hear that this is not even their primary purpose. Commodities are useful goods. There is no real reason to expect that holding a commodity would entitle you to any sort of premium, any more than I should expect a return premium for buying and holding a bag of coffee beans. Those coffee beans are there to use and enjoy a morning coffee, not to invest in. I should not expect my bag of coffee beans to go up in price on any theoretical grounds. I certainly should not invest in millions of pounds in tons of coffee beans and make this part of my asset allocation. The case for commodities is tough to justify. However, many investors seem to think commodities have an expected return. It may come from some assumption that where there is risk, there must be a return, or that because something is labelled an “asset,” it must have a positive expected return. Coffee bags are an asset too.

   
   

   There could be a way to get a positive return from commodities, if we are investing via futures (not spot commodities): holding futures instead of the commodities directly can potentially provide 'insurance' to commodity producers, by giving them a market to sell their future production at a fixed price, and the return would be the insurance premium paid by producers. However, this effect does not appear universal and seems to apply to only pro-cyclical commodities such as energies and industrial metals. As a result, the empirical evidence for spot commodity returns is weak, but it surprises us to see investors so confidently taking general commodities risk as if the case for a positive return premium were as strong as that for equities. 

5. Developed Market Currency Risk:  Currencies also have real uses like commodities, so they are not purely investable assets, but they do not carry a return premium. Currencies also run aground on symmetry arguments: a US based investor is taking price risk by holding Euros, but a Euro based investor is taking risk by holding US Dollars. They cannot both be getting a positive expected return. So, at least with developed market currencies (we think emerging markets are another story), the case for a return premium is very weak, and we think it is best to assume it is zero.

   
   

6. Real Estate Risk: Real estate is an interesting asset to consider, and we think it is inconclusive. Should investors expect a return premium from holding real estate? On the one hand, it is not a purely investable asset, it has real uses, as everybody needs a home, so why would a home carry a risk premium? Fundamentally, it is hard to imagine that our ancestors, living in self-made huts or caves, were sitting on an asset with a compensated return premium because they were bearing price risk. Everybody just needed a hut /cave and the “price risk” was something they needed to take on if they wanted a roof over their head. I cannot see a reason to expect they were getting compensated for it.

   
   

   On the other hand, one can think of the value of a property as the present value of a stream of rent payments. Since those rent payments are not riskless (voids, bad tenants), they should offer a return premium over the risk-free rate to the owner. In that sense, real estate is like a bond. This leads to the conclusion that real estate has a risk premium for investors who are renting out homes, but not for homeowners (or hut / cave owners). This would mean that the premium is earned through rent payments, and not through actual price appreciation of the property. Real estate real price appreciation  (inflation adjusted)  in the UK since 1900 according to some data is slightly negative (houses get old, so they depreciate too). Higher returns from real estate investments mostly come from including rental yields in the numbers.

7. Classic cars: Compared with commodities which could be still mined, classic cars have the advantage they are not produced anymore. However, apart from the possibility of renting them for events like weddings, there is no stream of income, there is usually a negative one, like the cost of insurance, maintenance, and storing. These assets are part of the “greatest fool theory”, finding someone else who will pay an even higher amount when sold. The prices of classic cars are influenced by fashion; some studies show that people who were young in 1960 – 1980 wanted to have a fast car but they could not afford one at that time; now when older and better off financially, it has become affordable. Daniel Kahneman, the Nobel prize winner, researched this and developed the incidental anchoring behavioural concept as a result.

8. Cryptocurrencies: The argument these are an asset is even harder. Let us start by breaking down the word ‘cryptocurrency’. The first part, ‘crypto’, comes from the Latin word for ‘hidden’ or ‘secret’. The name currency would indicate they are used to make payments and record who owns what, and crypto name shows the fact that they exist purely electronically (hidden), and there is no Central bank or Government to manage the system and step in if something goes wrong. So far, very few transactions were made using cryptocurrencies, and there is no interest paid for holding them overnight i.e. very few lenders and borrowers exist for cryptocurrencies. Compared with gold and other commodities, they have no use, I cannot drink one for my morning coffee. It is safe to say they are also part of the greatest fool theory, and as a result they have no return premium.

To conclude, the assessment of whether any given risk brings return is completely non-trivial, and requires a lot of thought, academic research, and empirical work to get right. It clarifies that a “risky asset” does not automatically have a return premium. 

To investors we recommend taking a two-step approach:

1. Understand what you own, by identifying the risks in your portfolio.

2. Go through your set of risks and figure out (perhaps after reading this article) which risks are compensating you, and which ones are not.

Step 1 is easier, but as you can see from this article, Step 2 is a lot harder. At N2 Asset Management we help our clients to calculate the investment return they need and following that to allocate to asset classes which have a high probability to provide those returns at the time and in the form that we identify together in the discovery meetings.

Please get in touch with us if you want to learn more.

IMPORTANT NOTE: The value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested.

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