The Most Misleading Finance Concept Of All Time

High risk = High return.?

You’ve probably heard it before: “riskier investments will provide higher returns”. Or “if you want more returns…just take more risk”.?

In a chart, it looks like that:

So why is “high risk = high return” the most misleading - and dangerous - concept in the world of finance??

Because it can mistakenly suggest that taking more risk will guarantee more returns.?

But here’s the thing: while higher risk should indeed lead to higher returns on average - investors don’t just take risk for fun after all - there’s no guarantee that these higher returns will actually materialize.??

In fact, the higher the risk,? the more likely the realized return will deviate from that average return, and the more likely a big loss will materialize.?

Howards Marks, the co-founder of Oaktree Capital Management, proposes a much better alternative to help us visualize the real relationship between risk and return:?

Source: Howard Marks, The Most Important Thing.

The “expected return” line is the same as in the previous chart: investors will only take more risk if they expect to generate higher returns. But Marks introduces the concept of uncertainty nicely with a curve representing the range of outcomes that can actually materialize.?

As Elroy Dimson elegantly puts it: “Risk means more things can happen than will happen”.

In other words, while investors should achieve higher returns, there's no certainty they will.?

Take US stocks for example: while on average they’ve returned 11% per annum since 1977, they'd have realized between +28% and -6% p.a. over a 5-year horizon.?Over shorter horizons, they'd have lost more than 40% multiple times.

Source: Portfoliovisualizer.com, InvestInU Academy

On average, you may be right, but you'll most likely always be wrong !

So yes, stock investors did clip attractive positive returns on average, but it’s to compensate for a) the huge uncertainty over what they’ll actually realize, and b) the potentially significant losses they can suffer.?

It’s a bit like leaving the safety of a job to start your own business: while the potential to become wealthy must be high enough for one to take the leap, there’s no guarantee the risk will pay off.?

So what??

The conclusion is not to avoid risky assets - after all, the only way to generate returns is to take some risk. The conclusion rather is that taking more risks won’t guarantee higher returns.?

To me, there are three practical takeaways from this:?

1. When investing, thinking about the distribution of potential returns is more important than just focusing on the average return.?Shorting volatility can for example provide some attractive “expected returns”, but failure to deal with the possibility of a significant crash (i.e. the distribution is negatively skewed) will make it highly unlikely to actually realize them - just ask anyone who invested in the XIV ETF.?
2. Hope for the best, but plan for the worse. Higher risk doesn’t guarantee higher returns...but it does guarantee a higher probability of realizing a loss, so make sure you plan for how you’ll deal with it.?
3. Seek diversification. By buying an asset that performs well if another doesn’t, you’re one step closer to realizing that “average” return.

Do you agree? Comments and feedback welcome!