Financial advisors have a jargon of their own, like most professions, and they love to spout pithy sayings. These sayings are not only based on valid observations and experience but they also help frame investment issues in terms most people can understand.
One of my favorites is the inescapable trade-off between risk and return. Simply put, you cannot expect higher potential returns without commensurately higher risk, and you cannot escape risk without the expectation of lower returns. Indeed, the efficiency of our markets ensures that money will flock to any investment that produces high returns with little risk and will flee areas with low returns and high risk. These capital flows bring risk and return back into balance.
It’s important to remember that risk and return have to be evaluated looking forward rather than back. The natural inclination to project our recent experience and observations is precisely why many investors end up buying high and selling low.
We’re all familiar with the ubiquitous “past performance is no guarantee of future results” disclaimer that accompanies all mutual fund prospectuses and ads. Potential return is best measured through long-term performance, which incorporates cycles of up and down periods, combined with measures of the current market environment such as valuations, interest rates, and economic activity. Consider both potential income and potential capital growth. In periods of high returns, ask the common sense question of whether those high returns can continue.
Risk is tougher to get a handle on; there are many statistical measures available but they are difficult to relate to real world conditions. Furthermore, many risks do not come to fruition, but this does not diminish their importance. I spoke with one investor who has owned single-family rental properties for many years and has never had a bad tenant, has never had vacancies, and has never had a neighborhood go downhill. Clearly, all these things happen regularly, but as far as he’s concerned, it’s been a risk-free proposition.
Consider risk and return as walking a tightrope. Obviously, you decide before starting whether the dangers are too great for whatever awaits at the other side. Greater risk means the rope is higher, or narrower, or shakier. You wouldn’t wait until you were plummeting to the ground to realize there was risk involved. And if you make it across unscathed and reap the rewards, it doesn’t mean there was no risk along the way.
Risks are a prominent feature in prospectuses and in company SEC filings, and they should not be dismissed. Look past recent events and focus on potential dangers. Beware of the false security trap that multiple events must occur at once to lose money because, sure enough, all those things will go wrong. Don’t forget to factor in your personal tolerance for risk; while some people thrive on the excitement and danger of the tightrope, others wouldn’t try it if the rope were an inch off the ground.
The current bond market offers an example of how all this works. Let’s consider two bond index funds, which practically eliminate several risks due to their wide diversification across government, mortgage and high-quality corporate bonds. That leaves interest rate risk, or the fluctuation in the price of the fund shares with changes in interest rates, as the biggest concern. Remember that as rates go up, bond prices fall, and vice versa.
The best indicator of sensitivity to interest rate changes is known as duration. Our first candidate, the Vanguard Short Term Bond Index Fund, recently had a duration of 2.4, so for every 1% change in interest rates, the price of the fund can be expected to change by 2.4%. Our second candidate, the Vanguard Long Term Bond Index Fund, had a duration of 11.0, or an 11% price change with each 1% change in interest rates. (Keep in mind that a change in interest rates refers to changes in the area of the market in which these funds invest, and all rates do not move in tandem. For example, the Federal Reserve has raised very short-term rates by 2% in the last year and a half, but long-term rates have changed very little.) Clearly, the Long Term fund carries over four times greater price risk should rates go up.
But are investors adequately compensated for that greater risk? Potential return is made up of the income paid by the fund and price changes driven by interest rate changes. The short term fund had an income yield of 3.81%, while the long term fund had a yield of 4.92%. The Long Term fund, with its greater risk, pays only 1.1% greater income.
Even this well-defined trade-off leaves room for judgment, particularly a guess as to what will happen with interest rates going forward. So what to do? Lacking a crystal ball, we do know that short term rates have already gone up 2%, while long term rates have actually gone down slightly. Based on both potential risk and potential return, the short term fund is the safer bet.