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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

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