Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 58

Think about risks as well as returns

When investors talk about stocks, the focus tends to be on which stocks have the potential to perform the best, and that is understandable. Professional fund managers typically do the same.

But portfolio risk management probably doesn’t get as much attention as it deserves. Risk management can make for boring conversation, but it is important for investors who hope to succeed over long periods of time.

In fact, in one sense, risk and return can be thought of as the same thing. This is best illustrated with an example. Imagine that you have two potential investments: one is an investment in a stock market index that is expected to return 10% per annum with a moderate level of risk. The other investment is in one stock that is expected to return 8% per annum but with half the risk of the stock market index. Let’s also assume you can borrow at an interest rate of 5%.

As a long term investor who is happy to accept the ups and downs of the stock market, you might think you are better off taking the 10% return, which should result in a better long term result. However, here is another way of thinking about it.

$100 invested in the first strategy has an expected return of $10 over one year, whereas $100 invested in the second has an expected return of $8 over one year. However, consider a strategy of investing $100 in the second stock, and also borrowing an additional $100 at 5% interest and investing that as well.

You now have $200 earning 8%, which gives you an expected return of $16. You will need to pay $5 of interest on the borrowed money, so your net return will be $11.

That $11 is better than the $10 you could get in the index, but what about risk – doesn’t the leverage make this a risky strategy? In this case, the answer is no. If the 8% strategy has half the risk of the 10% strategy, then in simple terms you can invest twice as much into that strategy and still have the same total level of risk. In other words, the leveraged approach that that gets you an $11 return has the same risk as the first strategy that gets you $10. Now which one should you prefer?

The point of all this is that risk and return can – to some extent – be thought of as substitutes for one another, and reducing risk can be worth just as much as getting a higher return. The consequence is that you can’t sensibly measure one without knowing something about the other.

This concept is important when comparing different fund managers. There is a tendency in the industry to rank fund managers on the returns they achieved over (for example) the last 12 months, with little regard to the risk taken to get those returns.

But managers have very different styles. Some will try to hit the ball out of the park by taking large bets on particular companies or themes, and even using leverage. When those bets succeed, that manager will be at the top of the league table (and will tell all and sundry about it). When they miss, the manager will be at the bottom (and stay relatively quiet). Managers who take a more cautious approach are less likely to be at either extreme.

Because of these differences, making performance comparisons is not a straightforward business. It is important for individual investors to think carefully about position sizes and in what circumstances they will hold cash or use leverage. It can be even more important in assessing fund managers: a manager who earns a performance fee in years when they do hit the ball out of the park is not going to give it back the following year if they strike out. As a result, high risk fund managers can impose substantial hidden costs on unwary investors. An investor should understand the risk as well as the expected return in any investment.

 

Roger Montgomery is the Founder and Chief Investment Officer at The Montgomery Fund, and author of the bestseller ‘Value.able

 

  •   17 April 2014
  • 2
  •      
  •   
banner

Most viewed in recent weeks

Are LICs licked?

LICs are continuing to struggle with large discounts and frustrated investors are wondering whether it’s worth holding onto them. This explains why the next 6-12 months will be make or break for many LICs.

Retirement income expectations hit new highs

Younger Australians think they’ll need $100k a year in retirement - nearly double what current retirees spend. Expectations are rising fast, but are they realistic or just another case of lifestyle inflation?

5 charts every retiree must see…

Retirement can be daunting for Australians facing financial uncertainty. Understand your goals, longevity challenges, inflation impacts, market risks, and components of retirement income with these crucial charts.

Why super returns may be heading lower

Five mega trends point to risks of a more inflation prone and lower growth environment. This, along with rich market valuations, should constrain medium term superannuation returns to around 5% per annum.

The hidden property empire of Australia’s politicians

With rising home prices and falling affordability, political leaders preach reform. But asset disclosures show many are heavily invested in property - raising doubts about whose interests housing policy really protects.

Preparing for aged care

Whether for yourself or a family member, it’s never too early to start thinking about aged care. This looks at the best ways to plan ahead, as well as the changes coming to aged care from November 1 this year.

Latest Updates

Shares

Four best-ever charts for every adviser and investor

In any year since 1875, if you'd invested in the ASX, turned away and come back eight years later, your average return would be 120% with no negative periods. It's just one of the must-have stats that all investors should know.

Our experts on Jim Chalmers' super tax backdown

Labor has caved to pressure on key parts of the Division 296 tax, though also added some important nuances. Here are six experts’ views on the changes and what they mean for you.        

Superannuation

When you can withdraw your super

You can’t freely withdraw your super before 65. You need to meet certain legal conditions tied to your age, whether you’ve retired, or if you're using a transition to retirement option. 

Retirement

A national guide to concession entitlements

Navigating retirement concessions is unnecessarily complex. This outlines a new project to help older Australians find what they’re entitled to - quickly, clearly, and with less stress. 

Property

The psychology of REIT investing

Market shocks and rallies test every investor’s resolve. This explores practical strategies to stay grounded - resisting panic in downturns and FOMO in booms - while focusing on long-term returns. 

Fixed interest

Bonds are copping a bad rap

Bonds have had a tough few years and many investors are turning to other assets to diversify their portfolios. However, bonds can still play a valuable role as a source of income and risk mitigation.

Strategy

Is it time to fire the consultants?

The NSW government is cutting the use of consultants. Universities have also been criticized for relying on consultants as cover for restructuring plans. But are consultants really the problem they're made out to be?

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.