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September 1, 1997 |
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High Risk And High Return I had dinner with my friend Sam last night. "I just invested $100,000 in this venture. It's a very high-risk situation but the returns will be astronomical if it works," he told me. "The way I see it, $100,000 is nothing compared to the potential returns. Anyway, I am not going to starve even if I lose the entire 100 grand." Sam remarked as we finished our second bottle of Cabernet. Indeed $100,000 is peanuts to Sam who has made a fortune in real estate. This morning (gosh, what a hangover), I started to think about what Sam said. The words "high risks" and "high returns" and "money that I can afford to lose" kept sloshing around in my head (together with all the residual Cabernet). It occurred to me that I had been down this road before. A few years ago, I invested $20,000 of my money under the same premise of high risk/high return and that it was money I could afford to lose. Well, the risks proved to be high but the gigantic return never materialized and I wish I still have my $20,000. How does one measure and evaluate risk? How does the interaction between risk and return influence one's decision-making? Does one always have to take on higher risks in order to earn higher returns? Are high risks acceptable just because one's total money at stake in the investment is low? Defining Risk Risk, as defined by the Webster Dictionary, is the possibility of loss or injury. The key word, I believe, is "possibility" as it focuses on the "likelihood" of loss or injury. To evaluate risk, one must be able to figure out the likelihood or the odds of loss or injury occurring. You figure out the odds by obtaining as much information as possible on the subject matter. The more knowledge you have on the subject the better your judgment of the odds will be, and therefore the lower the possibility of injury or loss. If you judge that the odds are against you, then you simply avoid the investment or course of action that will result in loss or injury. If you can't evaluate the odds for whatever reason (lack of information or expertise, future is too uncertain, etc.) then the risks are extremely high if you proceed with the investment (a roll of the dice). Return is often seen as the pot of gold waiting for you if and when you get there. Frequently this pot of gold is a very disruptive distraction in the evaluation of risks. Hole In One Suppose a group of golfers makes a bet with a duffer (the group's $10 against the duffer's $10) on whether the duffer can hit a hole in one in his next five games of golf. The duffer, without hesitation, will turn down the bet as the likelihood of him hitting a hole in one is close to zero (high risk low return). Now suppose the group went back and raised the stakes to $500,000 against the duffer's $10. All of a sudden the bet becomes a lot more palatable because the returns are attractive and what the heck it's only $10. This is a classic high-risk/high-return situation coupled with the powerful (but fallacious) thought that the risks are now justified by the increased returns and the exposure is peanuts compared to the potential returns. The duffer's risk has not changed at all. The likelihood of him hitting a hole in one is still close to zero. However, he may now be distracted (and feel justified) by the much bigger pot of gold that awaits him at the end of the rainbow - the possibility of making $500,000 with $10. In reality, the odds of him losing the $10 remains the same, whether the winnings are $10 or $500,000. However, the much bigger return may lure him into what has always been a losing proposition. Separating Risks And Returns This concept of camouflaging high risk with mouth-watering return combined with insignificant money at stake is the foundation of the lottery business. On a net basis, the house always wins. I believe risks should be evaluated separately from returns, or else the interaction between risks and rewards can be damagingly deceptive. A lot of bad investment decisions can be avoided if investors look at risks separately from returns. In the case of the duffer, if he evaluates his odds separately from the returns, he will not be tempted into accepting the bet. Whether the reward is $10 or $500,000, he will, in all likelihood, lose his $10 bet. If the odds are heavily stacked against you, then you should not pursue an investment irrespective of whether you have $10 or $10 million on the line, or of the size of the winnings. Return Analysis In investment and business valuation where future benefits/profits are discounted back to the present value, it is an accepted practice to slap on a higher return rate (also called discount rate) if the risk in an investment is high. The thinking is that if the risks are high then the investor should be compensated for it with a higher return. In this way the risks are justified. I feel strongly that this approach is misleading and will only muddle the analysis of risk and return (a lot of people will disagree with me). Risk is what you take on and return is what you get. The two are separate and absolute. Return is defined by the underlying economics of the investment and not by the risks involved. The odds are not going to change just because you demand a higher return. If the odds are against you and the investment is not worth pursuing then it is not worth pursuing no matter how high the returns or how insignificant your exposure. Slapping on higher return rates in an analysis won't change the risk (think of the duffer) and only results in garbage in and garbage out. Having a range of risk rates (so called sensitivity analysis) will only confuse things rather than clarify them in the valuation of investments. Worse, the arbitrary high return rate you slap on will give you a false sense of security and justification. Exceptions There are exceptions to the above "if the odds are against you then it is not worth pursuing no matter how attractive the returns" approach. In a corporation, many products in Research and Development are chancy and uncertain. A lot of the new products now in the marketplace would never have been created if the corporations behind them had taken purely the odds approach. In R and D, I believe one should have more of an "expense" mentality - pursue projects with substantial risks with the understanding that failures are part of the "costs" of creating new products. These are part of the operating expenses of a company. The record and movie businesses use a similar approach. Don't let the record or movie executives fool you. They don't have a handle on how to pick hits. That's why major record companies sign a lot of acts with the hope that the small number of hits will pay for all the flops. The same goes for the movie business. If you have to pursue lottery-type investments, then the best approach is to place as many bets as economically feasible to increase your chances of hitting the jackpot and hope that your winnings will cover all your losses. This is also the basic approach of Venture Capital. I've never bought a lottery ticket in my life (yet it's ironic that I invested $20,000 in a lottery type high risk/high return business). Low Risk And High Return One should avoid the lottery approach in investing (most people never win the lottery). The beauty of investing in the stock market is that it is not necessary to take on high risks to earn higher returns. In fact you can have low risks and high returns. Occasionally, during periods of human folly in the stock market, solid and established businesses will sell for a fraction of their real worth. If someone sells you a $10 bill for $6 then it is a no-risk and high-return situation. If pursued astutely, you can have venture capital type return rates in the stock market but with much lower risks. In Summary 1. Risk evaluation is the assessment of odds. 2. The higher the uncertainty, the higher the risks. 3. You reduce risk by having as much knowledge as possible in order to make a sound assessment of the odds. Risk is NOT reduced or justified by diversification or by demanding a higher return. 4. The level of return is not related to the level of risk involved. Return is determined by the underlying economics of the investment. 5. Risk and return should be evaluated separately. Do not let the pot of gold distract you in your investment decision. 6. If the odds are against you, then don't go ahead with the investment no matter how insignificant the amount of money you have at risk. |
