The Risk-Reward Relationship

 

Escarpment Edit50

Some years ago a coworker of mine, who is more than fifteen years my junior, posted a picture on Facebook. The photo was of her sitting on the edge of a cliff at an area known as the “Edge of the World”. The edge of the world is part of the Tuwaiq Escarpment, a place about 100 kilometers north of Riyadh, Saudi Arabia. The Tuwaiq Escarpment is a series of valleys, canyons, and cliffs in Central Asia known for its 600-meter high cliff called the “Edge of the World”. Unlike any similar location in the West, there are no railings keeping you from going out to the edge of the cliff and many people have taken advantage of this fact to obtain some pretty impressive pictures. These opportunities are not without peril as reports of visitors falling to their death are not unheard of.  

As you may have guessed, this was the picture my young colleague had taken. There she was, legs dangling off the side of a cliff some 600 meters above the cliff floor. It was an amazing picture. But it made me think about the relationship between risk and reward. For her, the reward was the experience. Sure she had the picture, but I’m certain that the real reward if asked was the experience. The risk was death, literally falling to her death. Therefore, I wondered, did she consciously weigh the consequences of her actions and come to a logical conclusion that the reward outweighed or overcompensated for the risk?  I didn’t ask her, but I would assume she did not. As is many times the case in youth, her decision to crawl out onto the edge of a cliff was most likely spontaneous with little, if any, thought of the risks.

I brought up the picture while chatting with her one afternoon and she indeed remarked that she didn’t realize, until looking at the picture afterward, how daring her photo op was. If she would have weighed the risks and the rewards, would she still have gone out upon that ledge? I didn’t ask.

Calculating Risks vs. Rewards

Many times every day, people weigh risks and rewards. I am not a behavioral psychologist, but I would propose that most of the time this is done without us even realizing it. Perhaps it is this subconscious, innate instinct that helps us survive. Not just survive death, but survive other risks. Perhaps this is why men heed legendary advice when answering the question, “How do I look in this dress?” The risks are totally unbalanced with any possible rewards. Also, perhaps this is why so many find it hard to tell their boss what they really think. The risks are high, the rewards are low. Alternatively, those who start their own businesses obviously take on high risks, but the perception of even higher rewards provide the much-needed incentive to proceed.  Sometimes in life risk versus reward is subjective. To one person, the rewards of starting one’s own business may seem to overcompensate for the risks, while for another they do not. As one grows older the equation of risk versus reward may change as well. Some twenty years ago, I would’ve found myself next to my colleague on the cliff’s edge, but today, the reward nowhere near justifies the risk.

Can we place objective calculations on risk/reward? Of course–insurance companies and financial institutions do it every day.  You can even place objective calculation on personal matters. One risk/reward formula I like to consider has to do with drinking alcohol. When you live many years in a country where alcohol is forbidden, it presents the opportunity to look at alcohol in perhaps a more coherent manner, or perhaps the right word would be obsessive. The idea of having a drink in most countries is one that would require very little thought – if you wanted one, you’d have one. But in a country where it is prohibited, you cannot simply have a drink. For some living under this prohibition, the subject of alcohol may be one that they never think about.  However, for others, it is a subject thought about regularly since its absence is quite noticeable.

A Case-Study using Alcohol

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Nevertheless, I have found it interesting to equate a risk/reward formula to the consumption of alcohol. There are admittedly subjective qualities to this equation such as how much fun one has while drinking or how you may feel the next day, but my goal is to assign objective components to its use. One thing that can be assigned is how many hours of alcohol consumption take place. I place this quantitative measure in the reward column because the intention of drinking alcohol is to feel good and most hours of the drinking process involve enjoyable activities such as talking, laughing, dancing, etc. However, if any time spent during this measurable period is spent in unpleasant activity (i.e. fighting, vomiting, arguing) this time must be allocated to the risk column as most people find these activities to be unpleasant.

However, for illustrative purposes, let’s assume that we have an enjoyable evening of alcohol consumption with none of the aforementioned unpleasantries. The amount of time-consuming alcohol will directly correlate with the amount of time recovering from its consumption. In my experience, I have found that as the hours of alcohol consumption rise so do the hours of recovery, and not in an equivalent manner. This may be a lobby for the “drink responsibly” mantra, but since alcohol is an intoxicant that affects cognitive functions such as reasoning, this slogan may prove to be more the clever marketing catchphrase dreamed up by the Distilled Spirits Council of the United States (DISCUS) than an actual possibility when indulging in this toxic depressant.

Nevertheless, if one is to reach a positive tradeoff between risk/reward in drinking, the following quantitative analysis must be true:  More time was spent feeling good (i.e. drinking) than was spent recovering (i.e. hangover). In other words, the reward of partying (with regards to time) was a positive exchange when compared to the risk, or hangover, of partying. Perhaps this is why people who can and do “drink responsibly’ are such proponents of its use. If you enjoy the company of a friend for two hours while having a couple of drinks, odds are that with proper sleep and sustenance you will feel completely fine the next day. In this scenario, the rewards of your activity positively out balanced the risks. But as one starts to prolong the fun of drinking and increase the rewards of such activity, he also increases the risks – to the point that the initial positive balance of reward starts to decline and risk/reward becomes equal or negatively balanced in favor of risk. Am I saying that the more you drink, the worse you feel? Sure, but you already know that. What I am pointing out is the longer you drink, the longer you feel poorly. And these two variables are by no means equal.

Obviously, in life, we want to maximize reward and minimize risk. But sometimes we may have a delusional view of how to do this. We may assume more risk thinking the reward will be worth it. Or the contrary: we may assume that something is riskier than it is, foregoing a potentially positive return.

Risk and Investments

When investing, this is very much the case. Some people put their income into high-risk investments thinking that the returns will compensate for the risk. Others believe that certain investments are too risky and therefore put their savings in an insured account, relinquishing any possibility for a positive return. Both are unsound strategies for wealth building.

First, let’s look at the saver who invests his money in high-risk securities. Most people would acknowledge that investing all of your savings in areas of high risk such as penny stocks, commodities, options, and futures is not wise. But I have talked to many people that hold the philosophy that allocating a small amount of your investment portfolio, say 10 -15%, to the above high-risk investments is not a bad idea. I say it is and here is why.

Let’s start by taking a look at the risky investments mentioned above. I put them in the order of penny stocks, commodities, options and futures because, in my experience, it is the degree of prevalence that a mainstream investor may dabble in.

Risky Investments

1. Penny Stocks

Penny stocks are stock issued by companies whose share price trades for less than $5. These companies are usually very small, make no profit and will most likely never amount to much. Ever heard the old saying, “There is a reason why it’s cheap?” Think penny stocks. Why do people buy them? Because they are cheap, you can most likely buy a lot of shares and – what if. What if the stock I just bought for 60 cents goes to $10? Well, guess what, it won’t. These stocks represent companies that do not make a profit and are therefore very risky.

There is even a number to measure their risk, it is called beta. Beta is the risk of an individual stock when compared to the overall market.  The overall stock market has a beta of 1. An individual stock with a beta of 1 will move in relation to that of the overall market. Some penny stocks have betas as high as 3 or 4. What this means is that these stocks have a volatility rating 3 to 4 times that of the overall market.  So because of this added risk, the return you should realize, in order to correlate with the added risk, should be 3 to 4 times overall market performance. Since one could expect an average return of 7% from the overall market, these holdings would have to return 21 – 28% annually to compensate for the risk you are taking. The problem with these penny stocks is that, not only do they not beat the overall market, the majority of them will not even match it and most will decline in price the longer you own them. Increased risk-taking should require a probability that the returns justify the added risk. Penny stocks, much like excessive drinking, do not fit these criteria and resemble gambling rather than investing.

2. Commodities

Commodities are another risky investment touted by some. These are things like oil, gold, silver, foreign currency, and even sugar and coffee. While very few investors would think about trading in sugar or coffee, more than you’d think are willing to speculate the future cost of precious metals or even the fluctuation of a foreign currency. The problem with this is that these markets are dominated by very sophisticated players such as hedge funds. Even gold, a commodity that we have seen appreciate over the years is limited as an investment option. For one, if you are actually buying gold, you have to store it and protect it. Furthermore, it will never give you any type of income. The best you can hope for is the appreciation of the metal itself.

However, many people own gold in the form of funds or even mining stock. Most people argue that gold is a safe bet to hedge, or evade, inflation. My problem with gold can be summed up from quoting a great mind. You guessed it, Mr. Smith. He declared, “If you believe that the world is going to end or that businesses are going to stop making profits, then buy all the gold you can because, if that happens, gold certainly will be a highly valuable commodity.” Well, I don’t think the world will end, not in my lifetime anyway. And I know that the number one goal of for-profit organizations is to maximize shareholder value. Any CEO that disagrees with that statement will most likely have no shareholders left once the words leave his mouth. My point here is that commodities, much like penny stocks, have a speculative nature. Even gold, which has had a good run up from $100 an ounce in the early 1970’s to $1,300 an ounce in 2014, only saw the majority of that appreciation in the last ten years. And there is nothing to say that will continue, as we have seen gold drop from $1,900 an ounce to its current $1,200 level in the last seven years. In the end, the speculative nature of commodities does not overcompensate for their risks.

3. Options and futures.

Finally, options and futures. Options and futures are derivatives that obtain their value from an underlying asset. In both scenarios, you are betting on the future price of that underlying asset. With futures, you have an obligation to buy the asset at the future price and with options, you have the option of buying the asset at the future price. Both are akin to gambling and have no business being in the common investor’s toolbox. Other speculative and high risk “investments” such as art, classic cars and timeshares are just that, speculative. If these assets were given a beta score it would likely be double digits. At the end of the day, the possible return for these assets can never satisfy the risk exposure for the typical investor.  

When I hear someone say that, because they are only allocating 10% of their investment portfolio to these types of investments, they will not be affected by their volatility, I can’t help but ask why. Why only 10% if these investments are so praiseworthy? Why not simply take the 10% and go to Vegas? Why sacrifice 10% of your hard earned money on high risk, speculative investments. Why be hungover all day for four hours of fun?

The Overall Market…Risky?

On the other side of the spectrum is the saver who believes the overall market is risky and wants nothing to do with it. To continue our analogy, we might liken this person to the teetotaler who is convinced that the consumption of alcohol is so dangerous that he never takes a drink. While the teetotaler may have a valid excuse, there are holes in his reasoning. For many, the obvious justification for having a drink or two, (i.e. drinking in moderation) is the health benefits. We have all heard the reported scientific evidence that moderate consumption of alcohol can be good for your heart, can reduce the possibility of stroke and even prolong life. While this very well may be true, it must be pointed out that the research is controversial and the chance of progressing into a habit of excessive drinking, beyond the levels considered safe, is a reality. Regardless, this is not my argument for the potential problems the teetotaler, as well as the market avoider, might face. The issue has to do more with what takes the place of the market, or the moderate drinking.

Many times those savers who overestimate the riskiness of the market will instead place their savings into areas of either high risk and low return, such as the investments discussed earlier, or low risk and low return, such as a certificate of deposit (CD) or a savings account. Both a CD and a savings account provide a miniscule return. At the time of this writing, the best interest rate on a 5 year CD is 3.4%, and the best savings account rate is 1.8%. Since inflation will average 3% a year, the expectation that a CD or savings account will add to your wealth is an illusion; they may not even preserve your wealth.

The irony is that some savers who believe the overall market to be too risky actually increase their risk exposure by investing in real estate or commodities, while others who are risk averse actually guarantee themselves an annual loss of by parking their cash in CDs or savings accounts. I liken this first scenario to the teetotaler who will never touch a drop of alcohol but instead drinks six Diet Cokes a day. And the second scenario to the teetotaler who disputes the positive effects of alcohol on the heart, but never exercises or watches their diet. The first has simply replaced static risk with volatile risk, while the other has wiped out the static risk, in return for guaranteed less favorable results.

We can never eliminate risk and we should never attempt to. Eliminating risk is not the point of life and not the point of investing. Calculated risk inevitably brings reward. The goal of investing, and many would say of life, is minimizing risk while maximizing reward. This can be done whether investing your hard earned savings, enjoying a cocktail with friends or even enjoying the edge of the world.

 

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