Risk and Returns

Risk commensurate with returns is a common notion among many people in the financial industry, be it financial planners or retail investors. The higher the risk, the higher the potential returns and vice-versa. However, whenever a banker or financial advisor tells me something along this line, I can't help cringing. From my experience, such statements are at best generalisations. I am suspicious that such sweeping declarations are introduced by the financial industry to mitigate adverse performance. My personal experience may not be accurate though, so I decided to investigate further. Here's the gist.

Looking at the US stock market, there are naturally a good number of risky companies that reaped great returns for investors over the long run. One of the most noteworthy is Concur Technologies. During the tech bubble crash in 2001, the share price of Concur Technologies plummeted but subsequently rebounded spectacularly.

Concur Technologies share price Dec 1999 ≈ $29

Concur Technologies share price March 2001 ≈ $0.31

Concur Technologies share price Dec 2010 ≈ $54.13

On the other hand, safe stocks, such as Microsoft, Apple and Walmart, can also yield fantastic returns over a 10 to 20-year period.

Walmart share price Jan 1980 ≈ $0.11

Walmart share price Jan 1990 ≈ $5.90

Walmart share price Oct 1999 ≈ $69.12

There are many more such examples so it is fair to say that safe stocks can also achieve great returns. The question is, are risky shares more likely to give higher returns than low-risk ones? I can't definitively answer this question as the data is blurry here. One cannot really tell exactly when a high-risk stock becomes low-risk or vice-versa. Think Enron, Lehman Brothers, Goldman Sach etc. However, bearing in mind the number of clearly risky company versus low-risk company going bust every year, I am inclined to believe that the average preformance of low-risk shares tend to be better than risky ones.

Coming back to Singapore, if I were to invest in a property in a low-risk area, it naturally has to be at or around Orchard Road. A riskier area would perhaps be Woodlands. Rewinding back to the 2^nd half of 2009, if I were to invest in buy a HDB flat in Woodlands, my flat in the 2^nd half of 2012 would easily be 25% - 40% higher than what I bought it at. Prices for top-end Orchard Road condominiums, such as Orchard Residences or Scotts Square, have however stayed flat over the same period.

On the other hand, there are some investments where additional risk may indeed correspond to additional returns. Wharton finance professor Gary Gorton and K. Geert Rouwenhorst, finance professor at the Yale School of Management, in their paper titled, "Facts and Fantasies about Commodity Futures”, found that investments in the futures index would have performed far better than investments in commodities bought on the spot market. From July 1959 to December 2004, compounding returns averaged 9.98% a year for the futures investment, versus 7.66% for an investment in the spot market.

What is clear is that higher risk does not necessarily equate to a better chance of higher returns. My two cents: each investment should be inspected on its own merits. In the long run, a great investment will largely depend on the fundamentals of the specific investment and timing (basically the price you buy and sell the investment at).