The relationship between risk and reward is a cornerstone of understanding long-term investing.

As we saw in a previous lesson, the various asset classes – cash, bonds, property, equities and so on – sit on a continuum of rising risk and reward.

• Cash is the least risky asset class – it’s often considered risk-free – but you also expect the lowest return from it.

• Bonds are riskier, and over the long-term their historical returns have been higher than from cash.

• Equities are the riskiest mainstream asset class. They’ve typically delivered the highest returns over the long-term.

Remember that when we say ‘risk’ here, we mean volatility – how much prices move around – although the risk most of us care about more – losing some or all our money – also applies.

Another – non-academic – way to think about risk is it’s the probability of something being worth less than you paid for it at some point in the future.

Cash in a bank never goes down in value. Shares can fall 5% in a day and crash 50% in a matter of months in a bear market, though that’s rare. But over the very long-term the returns from shares can be expected to trounce cash.

Why does this relationship hold? Because it has to.

Why risk taking usually pays in investing

If you think about it, why would anyone invest in a riskier asset class if they only expected to get the same return as from a less risky asset class? (And the latter with better sleep and fewer grey hairs, too.)

The odd person might make misguided bets.

But the market as a whole is considered to be rational and efficient, not an Edward Lear poem.1

If a riskier asset class appears to offer only the same return as a less risky one, then something has to give. The price of the riskier asset falls until it is cheap enough to offer sufficiently enticing expected returns to make up for its extra volatility.

• Why would you put up with fluctuating bonds prices if you don’t expect higher returns than from cash?

• Why risk the vertiginous death swoons of the stock market if you only expect to earn the same returns as from more stable bonds?

• Zooming into specific shares, why invest in a risky start-up company if you only expect to get the same return as from an established blue chip?

In every case the answer is your expectation of higher returns.

In general the market does a good job of sorting out the pricing of various asset classes at any time to match buyers and sellers at the different risk/reward points.2

We investors can then bolt together portfolios from the different asset classes with the aim of matching our overall risk tolerance.

But here comes the important point. Academics – who came up with all this theory – warn that the relationship of more risk, more reward does not always hold.

In some circumstances you take greater risk, yet you can’t expect the market gods to reward your chutzpah with greater returns.

Academics call these lousy bets uncompensated risk.

Uncompensated risk: Just say no

The classic example of uncompensated risk is buying shares in an individual company versus investing in the broad stock market.

Let’s say you expect shares in financial blogging firm Monevator Industries to deliver a 10% annualized return over the next decade.

Suppose you also believe the wider stock market will return 10% a year.

Now, there are many quirky things that can go wrong with Monevator Industries on the way to you earning your 10%.

• It could suffer an industrial accident.
• Its products could go out of fashion.
• Its CEO could buy a new apartment and get distracted from running the business.
• It could go bust.
• At the very least its price is likely to move around a lot to reflect the market’s shifting assessment of these factors.

Of course, the stock market as a whole will also go up and down, too. Its various constituents will have their woes.

But all companies in the market should not suffer the same business disasters at exactly the same time.

If you’ve got all your money in one stock, you’re therefore taking on a lot more risk than the market – including the risk of losing all your money.

But don’t panic! Holding more than one company immediately diversifies your portfolio, and reduces this risk.

And the more additional companies you hold, the more the company-specific risk is diversified away.

Estimates vary, but holding as few as a dozen-to-20 different shares3 gets rid of the bulk of the company-specific risk. By the time you’re up to 50-100 different holdings you’ll have to hunt for the decimal point.

At the extreme you can just buy the whole market via an index tracker fund. Now you have diversified away all the company-specific risk. You’re just left with the risk of holding equities as an asset class.

Why uncompensated risk doesn’t pay

According to that academic relationship between risk and reward, a risk that can be easily diversified away cannot be expected to reward you with higher returns.

Why?

It goes back to supply and demand.

If investors can reduce the risk of investing in any single accident-prone company by holding a bunch of them, then the risk of investing in companies isn’t such a big deal, after all.

Investors therefore won’t demand so much extra expected return to entice them to buy. They’ll take lower returns and diversify.

Because the risk of holding a few individual companies can be easily diversified away like this and not be expected to give you higher returns, it is said to be uncompensated risk.4

As a consequences, you should not expect to earn higher returns simply from running a more concentrated portfolio of shares.

Note: I am not saying that you can’t make money investing in a single company’s shares. Clearly you can! You might have put all your money into Amazon shares at a few dollars and now be a multi-millionaire. Similarly, you might have lost everything in failed bank Northern Rock. In efficient market theory you can’t know which will happen in advance. You just know “shit happens”, and that you can diversify away the risk.

Another example is currency risk. This risk of currencies moving against you can be hedged away and the impact nets out over the long-term with a global equity portfolio, so it is considered to be another uncompensated risk.

Active management is a zero sum game that overall reduces returns to investors through fees and other costs. So some argue that it too is also uncompensated risk.

If you buy one fund, you might do better or worse than the market. The more funds you own – the more you diversify – the more that risk goes away.

Eventually this logic takes you back to owning a total equity market index fund, where you expect higher returns compared to a less risky bond fund, but no special extra returns on top.

Key takeaways

• Generally-speaking, you will only get higher returns by taking on greater risk.

• However greater risk cannot always be expected to deliver higher returns.

• Risk that can be easily diversified away is called uncompensated risk.

• The market doesn’t pay you for uncompensated risk.

• Index tracking funds that invest across broad asset classes are an easy way to diversify.

This is one of an occasional series on investing for beginners. You can subscribe to get our articles emailed to you. Why not help a friend get started, too?

Note on comments: This series is for beginners, and any comments should reflect that please, rather than confuse or make irrelevant points. I will moderate hard. Thanks!

1. Sometimes this efficiency breaks down, as behavioural economists such as Nobel Prize winner Robert Shiller have shown. But almost everyone agrees it’s big picture efficient most of the time. [↩]
2. Yes, it goes crazy sometimes and seemingly gets it wrong – such as when we see market bubbles. Again, that’s a discussion for another day. [↩]
3. Chosen from different sectors. They can’t all be sausage makers or umbrella factories. That’s not diversified. [↩]
4. You might expect to do better than the market because you believe you’re a brilliant stock picker, but that’s another – very unlikely – bet altogether! [↩]

What caught my eye this week.

I remember the first time I heard the phrase ‘passive investing’ uttered by The Accumulator.

Or at least I think I do – I’m pretty sure I dozed off midway through the sentence.

I disliked the passive investing label from the start. Several years and hundreds of articles later, it still sounds a bit defeatist.

Words matter. As Preston McSwain recalls in an article I link to below:

[Investment expert] Charles Ellis was once asked: “What is the biggest risk investors face when investing in index funds?”

His answer?

“Being called passive.”

Yes, regardless of your investment background, deep down you are likely to be more attracted to an investment or firm that sounds dynamic and vibrant versus one that sounds docile and inert.

I can relate to that, for my sins. In contrast, ‘index investing’ I can easily get behind. Indexing sounds faintly clever and technical. Comfortingly nerdy.

It was also how I began investing nearly 20 years ago, and it was the reason I counted myself fortunate in snaring The Accumulator to write for Monevator a few years back.

I believed a portfolio of index funds was the best approach for most everyday investors, and still do. But given I was increasingly off in the weeds nurdling with my active investing, it was crucial to get somebody on board who was passionate about them.

And passionate my new co-blogger was – as passionate as any stock picker I’d ever met. He was deeply excited about expense ratios and the merits of rebalancing quarterly versus annually and whatnot. Things that mattered, in other words, rather than things which sounded good.

Which is probably why he wasn’t so phased by the weedy sounding ‘passive’ investing label. He gets his excitement elsewhere, as he’s written many times.

So passive investing – a term The Accumulator had picked up in his copious US reading – came with him to this site, and we even named our dedicated subsection accordingly.

But I’m made of weaker stuff, and I never loved it.

Others seem to increasingly feel the same way. Some have more sensible reasons, too.

As active costs fall, indexes proliferate, and supposedly passive investors shoehorn more esoteric ‘factor’ plays into their portfolios – rather than just tracking the global market – the lines are blurring.

Then you have all the hedge funds trading ETFs, which show up in some indexing statistics but are the antithesis of a passive approach. It’s all rather muddled.

I read several good articles and a podcast on this theme this week:

• Who is passive? – Preston McSwain
• Q&As on passive investing – Part 1 & Part 2 by Cullen Roche [He was early on this]
• Indexing sheds passive clothing – ETF.com
• The past, present, and future of ETFs [Excellent podcast, the short tax snippet is US-centric] – Invest Like The Best

These posts may confuse new investors, who I feel should learn the basic terminology before challenging it.

But once you know why index funds tend to beat their active counterparts, and why a *cough* passive approach is likely to turn out better than a lot of active management such as market timing attempts or sector chasing, it’s interesting stuff to ponder.

It’s also something I’m thinking about as The Accumulator does seem to be approaching the end of the first draft of our infamous book.

Should we celebrate the passive investing label in our book title and pitch? Or avoid it, and perhaps sell more copies and reach more people?

[continue reading…]

My views on Brexit – which are personal and as partisan as yours, so feel free to skip them all – plus the week’s good reads.

Two years after that Referendum result, and according to a survey by the Share Centre, 5% of its customers who voted Remain would now vote Leave.

That is more than double the percentage surveyed who voted Leave but would now switch to Remain. This, despite the whole shebang continuing to be basically the laughing stock of the world (when it’s not showing shades of something much more sinister, such as a anti-democratic power grab disguised as re-enfranchisement).

Still, perhaps that’s not surprising. The Brexit debate has been great for most Briton’s portfolios – I pretty much bought my flat on the back of it – mainly due to the fall in the pound.

International holdings soared in the immediate aftermath of the result, and UK markets soon followed since the big UK listed companies earn the lion’s share of their income overseas.

Most people seemed surprised by this at the time but it was very predictable. Unfortunately (on many levels) I can’t haughtily point you to a Monevator article I wrote before the Referendum pointing that out, as I maintained a no-Brexit discussion policy before the vote.

(It’s truly a shame, because in a convoluted way I lost a friend arguing about the pound in a Brexit scenario in the week before the vote. This isn’t the place to go into why or how it came to that – or what an injustice it is to now be estranged, given that I was urging him not to short the market ahead of the Leave win that he very unusually foresaw – but it’d be nice to at least have a post here as consolation. He may still read the site. Hello S., if so!)

The truth is I believed not bothering to get bogged down in what were already toxic Brexit debates ahead of the vote would be best for this site overall, not least because I thought we’d stay in.

I did think the result would be closer than many of my London friends believed, mainly due to differences in our upbringing I suspect.

However I never really believed a majority of the population would support the asinine case to leave. So I judged it would blow over and we could all stay friends.

Of course that didn’t happen. The country voted Leave, and like most of my ilk I put my head in my hands. I ranted a bit, like everyone, and lost a big chunk of readers who were also Leave voters when we all took sides. In fact, I recently found myself being described on another forum on the Internet as having had a “breakdown” in my first Brexit responses in the weeks that followed, which was an interesting experience.

(Now I know how it feels to be a public figure like Kim Kardashian! Well, perhaps a bit.)

Maybe I did have a bit of a wobbly moment there. However the past two years has only reinforced my feeling that the entire thing is an enormous undertaking – and a colossal waste of time for all but constitutional sticklers – that from an economic perspective could only have negative results1, and that reality was either not understood or willfully ignored by a good cohort of its supporters.

True, the economy has only slowed, not tanked. But otherwise Brexit has dragged on because everyone wants a different Brexit, and any Brexit is a logistical nightmare, let alone one that doesn’t send us into an immediate multi-year recession. (i.e. No deal, hard Brexit, and we’d have been out by now after an immediate triggering of Article 50).

Some of those who don’t read Monevator anymore said in the days after the vote “Get over it, the vote has happened, we need to move on.” I shuddered, because again I saw that they didn’t realize what they’d voted for. Two years on and Brexit is still item one or two on every news broadcast. It will be that way for years more to come.

I’m late to go to one of the restaurants that hasn’t yet been squeezed out of business by the first effects of Brexit, so no time to spell check or sense check this post.

I wanted it to be a bit more diplomatic, but probably there’s still too much snark in it if you did vote Leave. Perhaps that can’t be helped, and I’d feel the same if I read a similar post on your own blog.

At a time when the global temperature is rising, bees are dying, the leader of the Western World has gone rogue, the robots are coming for our (current) jobs, people are 10 years away from fighting land wars for water, and the only people who’ve really got rich from the past 10 years are the richest, I still feel the whole thing is a massive distraction that will solve nothing that really matters.

But fair enough, your mileage may vary.

[continue reading…]

1. Again, I reiterate they may only amount to say 0.25% off GDP annually in the long run, but that’s also huge in the long run. And for what? [↩]