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Risk and Return Are Interchangeable

Today I want to talk about one of the investing lessons that took me the longest to learn and really internalize. And, when talking with clients and corresponding with blog readers, it’s clear that this topic is one of the biggest gaps in many people’s investment knowledge.

Anybody who has been studying investing for any period of time is aware of the relationship between risk and return: safer investments tend to offer lower returns. Cash typically earns lower returns than bonds. Bonds typically earn lower returns than stocks. Safer bonds typically earn lower returns than riskier bonds. And so on.

Similarly, it’s not hard to grasp the idea that we would always like our portfolios to provide the greatest amount of return possible for a given level of risk. Why not, right?

But the full ramifications of that idea — that we want the greatest amount of return for a given level of risk — are deeper than most novice investors really understand.

It means that an increase in return is not, in itself, a good thing. And it means that a reduction in risk is not, in itself, a good thing. In each case, we have to ask: “in exchange for what?”

That is, outside of the extremes (i.e., portfolios that are already 100% stock or 100% cash), we already have an easy way to adjust the risk/return level of the portfolio: adjust the allocation between stocks/bonds/cash. Doing so is free and extremely easy. So if somebody points out some way to increase the return of your portfolio, the first thing you must ask is whether the strategy being proposed is any better than simply adjusting the stock allocation upward. And if somebody points out some way to reduce the risk of your portfolio, you must ask whether the strategy being proposed is any better than simply adjusting the stock allocation downward.

That’s the hurdle that must be met: “is this better than simply adjusting my stock/bond/cash allocation?” And you must always keep this in mind, otherwise you’ll be sold a bunch of nonsense over the years.

But here’s the part that took me an especially long time to internalize: a reduction in risk without a corresponding reduction in return is effectively the same thing as an increase in return. If you can find a way to keep the return the same and reduce your risk, then you could slightly nudge the stock/bond allocation of the portfolio upward in order to bring your risk back to what it was before, while now having a higher level of return.

Similarly, if you can find a way to increase return without increasing risk, that’s effectively the same thing as a reduction in risk — because you could nudge the stock/bond allocation of the portfolio slightly safer, in order to bring the expected return back to what it was before, but now with lower risk.

Risk and return are interchangeable.

And that’s the holy grail that the investment industry is always seeking: an unusually high level of return for any given level of risk, whether that’s better-than-cash returns for a cash-like level of risk, better-than-bonds returns for a bond-like level of risk, or better-than-stocks returns for a stock-like level of risk. Any of the above means you have achieved some magic.

Of course, reliably achieving such magic is nearly impossible. And when somebody tells you that such magic can be achieved, it’s prudent to be very skeptical.

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