Conventional wisdom on the relationship between risk and return is wrong
Ask almost anyone who you think is knowledgeable about financial matters, and you will be told that risk and return go hand in hand, i.e., the more risk you are willing to take, the more returns you are likely to earn, and conversely, the less risk you are willing to take, the less returns you are likely to earn. Ask almost any investment manager or counsellor and he will agree with this statement. So will almost any finance, business, or economics professor. Indeed, modern economic theory is based on the assumption that risk and return are positively correlated. Much of what you read in business, finance, and economics textbooks is based on that assumption.
A Few Questions
What is the true relationship between risk and return? Before I answer that question, I would like you to think about the answers to the following questions:
If risk and return are supposed to be positively correlated, then why is it, that gamblers in a casino, who seek risk as well as the so-called commensurate rewards that goes with it, often lose? And why is it, that prudent investors, who shun risk, often win? Why is it, that companies which have highly risky capital structures, i.e., large amounts of debt cushioned by small amounts of equity, tend to fail much more during period of economic contraction, than companies with conservative capital structures? Why is it, that companies which operate risky businesses such as manufacturing and selling computers, tend to fail much more than companies which operate stable businesses such as manufacturing and selling razor blades?
Graham-and-Doddsville
There was a time, many years ago, when, like almost everybody else, I too, used to think that risk and return go hand in hand and, therefore, the only way to increase returns was to assume higher risks. Then, one day, I came across the transcript of a talk given at Columbia University in 1984 by the legendary investor Warren Buffett. The talk was titled, "The Superinvestors of Graham-and-Doddsville" and one passage in it caught my eye:
"I would like to say one important thing about risk and reward. Sometimes risk and reward are correlated in a positive fashion. If someone were to say to me, "I have here a six-shooter and I have slipped one cartridge into it. Why don't you just spin it and pull it once? If you survive, I will give you $1 million." I would decline - perhaps stating that $1 million is not enough. Then he might offer me $5 million to pull the trigger twice - now that would be a positive correlation between risk and reward!
The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it's riskier than when you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is."
Tweedy Browne
In the above-mentioned talk, Buffett spoke of several investors he knew, who had produced exceptionally high returns over long periods of time, by taking very little risk. Indeed, their subsequent record, i.e., from 1984 till date, has continued to be exceptionally good as well, strengthening Buffett's argument that such exceptional returns were not produced because these investors were merely lucky. The record of these investors, Buffett reasoned, cannot be explained by economic theory based on the notion that risk and reward go hand in hand.
There was one common thing among all the superinvestors referred to by Buffett in his talk. All of them, like Buffett, believed that risk and return are negatively correlated, i.e., in order to increase returns, one has to reduce risk, not increase it. Consider the following statement made by the partners of one firm mentioned by Buffett in his talk - Tweedy Browne Company LP:
"One of the many unique and advantageous aspects of value investing is that the larger the discount from intrinsic value, the greater the margin of safety and the greater potential return when the stock price moves back to intrinsic value. Contrary to the view of modern portfolio theorists that increased returns can only be achieved by taking greater levels of risk, value investing is predicated on the notion that increased returns are associated with a greater margin of safety, i.e., lower risk."
Beloved Beta
Earlier, I mentioned that much of economic theory is based on the assumption that risk and return are positively correlated. Modern Portfolio Theory (MPT) defines that risk as volatility. Under MPT, the more volatile a stock, the more risky it will be. And just how is this volatility calculated? First, the past returns produced by a stock are compared with the past returns produced by the overall market. Then a line of trend is drawn to explain the relationship between the past returns from the stock and the past returns from the market. Then it is assumed that the line of trend will continue in the future as well. The slope of that line, called beta, is the measure of risk, as defined by MPT. Beta can have a positive or a negative value. The market is assumed to have a beta of 1. If a stock has a beta of +2, this means that if the market moves up by 20%, the stock should also move up, but by 40%. Conversely, if the market drops by 20%, the stock should drop by 40%. High beta stocks, those that move more than the market, are supposed to be risky, and low beta stocks are supposed to be less risky.
According to MPT, therefore, to measure risk, all one has to do is to focus on the beta of the thousands of securities available. If an investor wants higher returns, he must buy high-beta stocks. On the other hand, a conservative investor, one who does not want high risk, says MPT, must buy low-beta stocks.
Imagine, what the proponents of MPT advice: don't focus on the business risk, i.e., what the company makes, the competition it faces, the quality of its management etc. Instead, just focus on beta. Want high returns? Simply buy high-beta stocks and presto, you will earn high returns. Want low risk? Simply buy low-beta stocks, and presto, your risk will be low and so will your returns.
Take two companies - A and B and assume that the beta of both are identical. Company A makes and sells computers. Company B makes and sells razor blades. Company A is highly leveraged. Company B is conservatively financed. Company A's management is not only incompetent, but also dishonest. Company B's management is competent and honest. For an investor, which company is more risky - A or B? Common sense says that other things remaining the same, company A is far more risky than company B. But, the proponents of MPT will not agree. They will argue that since A and B have identical betas, they must be equally risky and which, therefore, will produce equal investment returns. To such people common sense factors such as the economics of the business, its long-term prospects, management attributes etc., simply do not matter. Only one thing matters: beta.
There is only one problem, with beta, however: It does not work in the real world. Several academic studies have shown that portfolios consisting of high-beta stocks do not necessarily produce high returns and conversely, portfolios consisting of low-beta stocks do not necessarily produce low returns.
An Illuminating Example
To demonstrate how silly the concept of beta is, Buffett gave an example from his own investment experience in The Washington Post Company. He spoke these words in 1984:
"The Washington Post company in 1973 was selling for $80 million in the market. At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more. The company owned the Post, Newsweek, plus several television stations in major markets. Those same properties are worth $2 billion now, so the person who would have paid $400 million would not have been crazy.
Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta would have been greater. And to people who think beta measures risk, the cheaper price would have made it look riskier. This is truly Alice in Wonderland. I have never been able to figure out why it's riskier to buy $400 million worth of properties for $40 million than $80 million. And, as a matter of fact, if you buy a group of such securities and you know anything at all about business valuation, there is essentially no risk in buying $400 million for $80 million, particularly if you do it by buying ten $40 million piles for $8 million each."
So much for beta, a concept, worshipped by many academics as well as investment practitioners and counsellors, and ridiculed by many extraordinarily successful investors. If beta really measured risk, then why is it that its proponents are not rich, and why is it that people like Buffett and the partners of Tweedy Browne as well as many more, who ridicule beta, are rich? The answer is simple: beta is not a measure of risk and risk and return are negatively correlated.
The reality about risk is that it is not something that can be reduced to a statistical number. Risk is not a hard, measurable number. Rather, it is a concept which can be understood by using the framework offered to the world by (who else?) Warren Buffett.
The Buffett Framework of Risk
That Buffett does not love beta, would be clear to you by now. Beta measures volatility and volatility is not the same thing as risk. To define risk, Buffett much prefers to use the dictionary. According to the dictionary, risk is "the possibility of loss or injury." Using this simple definition of risk, one can see that a business or an investment is riskier, if it carries with it, a higher possibility of loss or injury than a business or an investment which carries with it a lower possibility of loss or injury.
Financial risk comes from leverage. Other things remaining the same, a company which finances its business primarily from debt is far more risky than a company which finances its business primarily from equity. But financial risk is not the only risk that investors need to focus on. There is also the risk called "business risk" It is this business risk that Buffett focused on in a masterpiece letter which he wrote to the shareholders of his company, Berkshire Hathaway Inc., in its annual report for 1993. In that letter, he suggested five factors investors should focus on, in order to estimate the risk inherent in any business:
Think of a "safe" bank account yielding an interest of 5% a year. In an era when prices rise by an average of 5% a year, the real long-term return on this so-called safe investment will be zero. Even though your principal will be safe, your purchasing power will not rise. Indeed, if inflation averaged 8% a year, as it has in India over the last many decades, such an investment will produce an negative annual average real return of 3%.
Is that safe, or is it highly risky? To thousands of Indians, who keep most of their money in saving bank accounts yielding low rates of interest, the answer to that question will become clear, when, many years from now, they will see that even though the principal in their accounts remained safe, the purchasing power of the money got eroded.
If you use Buffett's framework of understanding risk, you will see that by keeping your money in the so-called safe bank account, you are taking an extraordinarily high risk with your money. Indeed, because inflation is certain to erode most, if not all, the returns produced by saving banks accounts, by putting much of your funds in such accounts, you would be speculating with your money, instead of saving or investing it.
Conclusion
There is no other investment-related concept in the world, which, in my opinion, is more misunderstood by most people, than that of risk and its true relationship with return.
The above article was written with the intention of showing you, just how contrary to popular opinion is Buffett's (and that of some others) thinking on risk. Risk, to Buffett, is not the same thing as what most people think. A wildly fluctuating stock market is not risky for the thoughtful investor, but putting his money in a low-yielding bank account is. Moreover, risk and return are not positively correlated; they are negatively correlated.
If you want to increase your wealth, then you will have to learn the true meaning of risk, and then, you will have to learn to avoid it, not seek it.
Note
This article is submitted by Sanjay Bakshi who is the Chief Executive Officer of a New Delhi based company called Corporate Investment Research Private Limited.
© Sanjay Bakshi. 1997.