High Risk IS High Reward - Here's Why
- Money Maverick
- Sep 12, 2019
- 7 min read
Updated: Feb 9, 2023
And other useful and factual takeaways.
Money Maverick spent some time in Perth last week, trying very much to escape the clown fiesta that is life.
Of course, while he was there - he did come up with Theoretical Applications For How People Can Choose Their Insurance, but apparently that wasn't nearly as exciting a topic as he thought it would be.
...I guess hopefully some insurance-obsessed academic will eventually ask me about it, but eh.
In any case, reading was on the agenda for the trip, and one of the books was 'You Can Be a Stock Market Genius' by Joel GreenBlatt.
It's a pretty old book - but for context, Joel Greenblatt is a fund manager who beat the DOW with returns of 50% a year for over 10 years.
Annualized, not cumulative. On average.
If you've looked at my previous post on aggressive investing, you know that this is no small feat.
Yes, the annualized yield of this total clown fiesta in the picture is a mere 5.2% annualized a year. (by the way, this is the SNP500.) You can refer to this article below on how absolute returns are more important than annualized, though.
So 10 times THAT isn't something that can be overlooked by anyone on the planet.
For context, let's look at at sum of $100,000 in 10 years.
SNP500 (1998 - 2007. 5.2% annualized): $100,000 becomes $166,018 [+66.018%]
Greenblatt Fund (1985 - 1994. 50% annualized): $100,000 becomes $5,766,503. [+5766.503%]
Almost a 5700% difference, and 5.6 million dollars. Pretty monstrous, so I'm going to sum up the take-aways that mattered to me and hopefully you see how relevant it is to you.
Enjoy.
Takeaway 1: The retail investor has many advantages that a Fund Manager may not have
Fund Managers manage millions of dollars, maybe even hundreds of millions of dollars. This applies to both passive and active - your STI ETF, your Robos - they experience the same host of problems.
While there are obvious advantages to institutional investing such as cheaper entry, there comes a whole host of problems such as:
i) Limited strategy imposed by dollar size of portfolio
ii) Legal issues
iii) Fiduciary considerations
iv) Trying not to affect share prices
v) Judged constantly
Most of these are fairly understandable just by looking at the statement alone, but I want to talk about (v) a little bit because a while back, I was discussing with prominent options traders on strategies and returns and why they didn't simply make a business out of their returns, which typically go for 24% or higher year on year.
You have to understand that these are the statistical minorities, very much like the fund managers who succeed in efficient markets like the US. So even after years of learning to be highly adaptable and creating income streams for themselves, most people tend to operate better without the pressure.
If you're a DIY investor who insists on DIY investing, I'd suggest you try not to put too much pressure on yourself or have a lot of people know what you're doing - especially because according to Dalbar studies, you have an even lower probability of doing well.
Much like Financial Planning, set very clear goals for your portfolio - not just because Singtel has a nice dividend - and recognize that not only are you NOT an institution, but it's advantageous not to be like one because you don't have to be accountable to thousands of other people every quarter.
Takeaway 2: Decent Concentration is likely better than Mindless Diversification
Based on past history, the average annual return from investing in the stock market (SNP500) is approximately 10 percent. Statistics say the chance of any year's return falling between -8 and +28 are about 2 out of 3. In statistical talk, the standard deviation is any one year is about 18 percent.*
Obviously, there is still a 1/3 chance of falling outside this range.
What do statistics say if your portfolio is limited to only five securities? The answer, surprisingly, is that your return will fall in a range of -11 to +31 percent. The expected return still remains at 10 percent.
If there are eight stocks, it narrows a little further, to -10% to +30%.
Not a significant difference from owning 500 stocks - in fact, an argument could be even made for having less stocks for a higher annualized return.
Taking a concentrated position beyond that point is advantageous because your higher volatility is likely outweighed by far higher long term returns.
I personally prefer to have concentration in a particular sector or geography with the rest balanced out in some kind of diversification for experienced investors - comfortable 10% annualized, likely significantly higher.
Which brings us to our next point...
Takeaway 3: Don't screw up a perfectly good stock-market strategy by diversifying your way into mediocre returns
Because these articles are fairly technical, I do get some experienced investors looking to diversify.
I've done this quite a bit, although reading this with examples reinforced it - so I'll tell you what I told them: it's important not to think of your investment portfolio as a separate entity from the rest of your life.
Let me try to illustrate what I mean.
So maybe you're a Bogle 3 Fund person [Local Stocks, International Stocks and International Bonds], or a Trident person [Stocks, Bonds, Gold].
Take the Bogle 3 for instance, with a little bit more aggression [80% Stocks, 20% Bonds]
If you have $250,000 - your investment portfolio might look like this.
What tends to happen is that mot people forget that this portfolio is only a portion of their entire holdings.
Just because these are actively managed by you (to some degree, as you claim responsibility over what happens, selling, rebalancing, etc) does not mean that the other aspects of your life do not fall under this portfolio.
Most people have savings accounts, or their DBS Multiplier. Or CPF.
Or Money Market funds. Their property. Perhaps individual bonds, or bond components like Astrea/SSB, life insurance, etc.
And your actual portfolio suddenly looks like this instead.
$250, 000 - Investment Portfolio [Aggressive, 80 -20]
$100,000 - Cash
$100,000 - Life Insurance
$400,000 - Property
$150,000 - Astrea Bond
In a Million Dollar Portfolio, 40% of that is taken up by your property.
In the entire context, that $200,000 which once held the majority of your portfolio turns out to be too little in what could easily be considered a very, VERY defensive portfolio.
Diversified? Certainly. Safer? Probably.
High Yielding? Almost certainly not.
Re-balancing? Whew.
Takeaway 4: High Risk IS High Reward
Finally.
After it was debated on Seedly twice - most recently from when Loo Cheng Chuan posted a picture - I'm going to attempt to put an end to the debate (and reinforce my hypothesis).
One cherished and immutable law of investing is that there is a trade-off between risk and reward. The more risk you assume in your portfolio, the more reward you receive in the form of higher returns, and vice versa.
Some proponents would argue that high risk doesn't necessarily equal high reward despite the majority of statistics suggesting otherwise. That's always baffled me.
So you have guys like myself, who dial up the risk to receive an appropriate amount of reward (and maybe explore an inefficient area to receive even more inappropriate amounts of reward).
Versus the guys who aren't convinced that higher risk means higher return, but acknowledge that it MAY mean higher return.
As it turns out, everybody can be correct.
It ultimately boils down to how we define risk.
Risk, according to generally accepted wisdom, is defined as the risk of receiving volatile returns. The calculation of beta, for example, is based on analyzing of a stock's past price volatility.
The distinction between upside volatility and downside volatility is no different when measured by this professional definition.
In English, this means that a Fund that moves up say...+40% in 4 months, is considered more risky than a fund that does -0.5% a month on a regular basis.
A more extreme example is if Fund A drops from $20 to $10, while Fund B drops from $11 to $10.
Both Funds are now priced at $10 a unit, but Fund B is considered less risky on surface analysis - despite the much higher probability that most of Fund A's downside is likely almost, if not over, already.
In other words, by professional and statistical measures, this...
Is SAFER, than this...
If we define risk simply by the history of how badly something can drop and never recover - sure, we might not always get high returns.
But if we define risk by the 'risk of receiving volatile returns', then you pretty much have to acknowledge higher risk = higher return, especially in efficient markets.
Especially because the better your return is, the more likely your volatility is recorded - included upside.
You can see this very clearly in my analysis of the SNP500, which already possesses amazing volatility despite being made out of 500 blue chip stocks.
Takeaway 5: There are, in fact - fundamental changes to the markets
This is something that I vastly underestimated at an early point in my career when I was learning about the different investing sectors and geographies.
There are 10 major sectors and we tend to think of them as wholes, but it's not so clear cut now. For example, Healthcare tends to get rolled into Biotech, or even a Health REIT.
So you imagine when you break it down into all the further sub categories.
Monopoly newspapers and network broadcasters used to be considered defensive, foolproof businesses. Imagine thinking a newspaper business is foolproof today. That would get any decent stock investor in stitches.
Gold and silver used to be primary currency.
Energy was the strongest all-rounded sector in US history for almost 50 years.
None of that is true or useful in the present. Sometimes the market moves in a fundamentally different way that changes everything you thought and planned for.
And you have to be ready.
Closing Thoughts
There were actually a lot more takeaways, but every good investor has to figure out how it applies to them and account for context. In any case, most of these pointers are useful to you - whether:
1) You're a consultant like myself, who seeks to bring returns to clients through commitment, good fund selection and exemplary service
2) You're a passive fund investor who is figuring out DIY and learning to adjust your expectations which stomaching volatility.
(For example, that safe, 500 blue chip stock ETF? That's had an 89% bear market drop before.)
3) You're a stock investor, looking out for strong future growth opportunities and value opportunities.
4) You're someone who is looking for a trusted Financial Consultant to start investing with.
Do drop a comment if you'd like to explore your options with a licensed consult and Investment Specialist, who can make these numbers into reality for you and your future.
Don’t skip out on opportunities because of fear.
Money Maverick
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Sources:
1) You can be a Stock Market Genius - Joel GreenBlatt
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