Risk and return

Risk and return is a complex topic. There are many types of risk, and many ways to evaluate and measure risk.

In investing, a widely used definition of risk is: "The chance that an investment's actual return will be different than expected." In this context, different means a variation which can go either positive or negative, and is known as volatility.

However, risk is a term often used to imply downside risk, meaning the uncertainty of a return and the potential for financial loss. The Merriam-Webster dictionary defines risk as "the chance that an investment (as a stock or commodity) will lose value".

This article demonstrates some of the concepts of risk, return, and diversification.

Risk as the uncertainty of returns
Refer to Figure 1 below. The uncertainty inherent in investing is demonstrated by the historical distributions of returns of three major asset classes: cash (typically studied in the form of Treasury bills),  bonds, and stocks. A span of 41 years (1970 - 2011) should be a sufficiently long time to show general trends, but 1982 had a significant impact and is highlighted separately. 

As shown in the left/top chart, the left vertical bar represents the range of annual returns for treasury bills. The range (dispersion) of returns is from slightly above 0% to 19%.

The middle vertical bar represents the range of annual returns on bonds over the same time period. Note the larger range (dispersion) of returns; from about -7% to +27% (excluding 1982).

The far right vertical bar in the left chart represents the range of annual returns on Canadian stocks (as represented by stocks in the TSX/Composite index) over the same time period. Note the much larger dispersion of returns; from about -33% to +45%.

The right/bottom chart in Figure 1 represents similar data from the US (3 month treasury bills, 10 year bonds, S&P 500 index) over the same time period. Note that 1982 also had a similar effect on U.S. bonds.

Figure 2 shows this same information, but from a different perspective. These histograms show how many years each return falls within a certain range (5% "bin"). The top chart shows that T-Bills had returns around 5% for 17 years (and 10% for another 17 years) out of the 1970 - 2011 period. The middle chart shows bonds had 10 years around 15% return, and the bottom chart shows stocks had 7 years around 15% return for the same period.

The focus is on the grouping of the vertical bars (dispersion). The T-Bill bars are grouped close together, bonds further apart, and stocks cover the full range.

Therefore, the uncertainty of returns (volatility) shows that bonds have more uncertainty than cash, and stocks have more uncertainty than bonds. Said differently; stocks are riskier than bonds, which is riskier than cash (T-Bills).

Another area of interest is the expected return. Although it is not clear from the data supplied here (but can be seen in the US data), the expected return increases with increasing risk. Investors want to get compensated for taking a chance that their investments may experience a loss. This is a nearly universal concept and is one of the first principles of investing:

Now, let's look at bonds. From Figure 1, 1982 had a significant impact. Figure 2 shows that there was a single occurrence - one year with a return of 45% (details are in the spreadsheet). Will this happen again? It's not possible to predict. This brings about another first principle of investing:

Portfolio diversification
Now, combine those same assets into portfolios. Refer to Figure 3.

The Treasury bonds and bills have been combined into a single category called "bonds." This is done intentionally, as asset classes which contain  bonds and treasury bills are commonly grouped together as fixed income.

Going from left to right, the portfolio progresses from (20% stocks / 80% bonds) to (80% stocks / 20% bonds). Similar to Figure 2, the least variation is a portfolio which contains mostly bonds; the highest variation is a portfolio containing mostly stocks. (In many portfolios, the highest risk also has the highest return - but those results are not seen in this data.)


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Figure 3. Risk vs. Return for Various Portfolios: 1970 - 2011
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Caveat: Figure 3 shows a hypothetical portfolio of assets held from 1970 - 2011 and should not be compared with an actual portfolio. Do not assume that the returns vary evenly (linearly) across the portfolio percentages.

There is a statistical method which attempts to predict the maximum expected loss of a portfolio. Known as Value at risk, there was a 95% confidence that the loss of these portfolios would not exceed (lose more than) the value shown in the table. However, 2008 proved the statisticians wrong. Investors who sold assets during 2008 experienced traumatic losses; but those holding assets for the long term (many years) will recover. 2008 is represented as the lowest return in the Figure 2 histogram, lower chart (1974 is the 2nd lowest return, at -26%).

This demonstrates that one can reduce their portfolio risk by adding bonds, which may result in a lower return (seen in many portfolios, but not here). Alternatively, one can increase their return by adding stocks, at an increased risk of loss.

Diversifying your portfolio is the only way to mitigate risk. It is a compromise of investing horizon (how long until the funds are needed) and acceptable loss. Diversification is determined by setting the ratio of equities (stocks) to bonds, and is known as asset allocation.

Papers
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