印刷する
Share

Blog

Basic mistake – Why one lesson of ‘Finance 1.01’ is ‘Wrong. All wrong’

23/12/2014

Jamie Lowry

Jamie Lowry

Fund Manager, Equity Value

Any student of finance or economics will recognise the chart below. It shows the graphical relationship between risk and return – the idea that, as investors take on more risk, they should be compensated with more return. The leap people tend to make from this is that, in order to earn greater returns, they need take more risk – but is that a correct conclusion?

Basic Mistake chart 1

Source: Oaktree Capital Management LP

Is this lesson from ‘Finance 1.01’ really teaching us that risky investments produce higher returns and so, if we want to make more money, we need to take more risk? Well, if it is, we should not be listening. As Howard Marks, the chairman of Oaktree Capital and a favourite of The Value Perspective, succinctly puts it in a recent memo to clients, Risk revisited: “Both of these formulations are terrible.”

Marks goes on to explain: “In brief, if riskier investments could be counted on to produce higher returns, they would not be riskier. Misplaced reliance on the benefits of risk bearing has led investors to some very unpleasant surprises.” Clearly there is an issue with the above graph and Marks offers the following as an alternative.

Basic Mistake chart 2

Source: Oaktree Capital Management LP

What this graph does is introduce the idea of odds and ranges of outcomes rather than a particular return and, as such, it is a much better representation of what the first graph is trying to say. Marks’s point is that riskier investments have to appear to hold the promise of a greater return but that is not the same as guaranteeing a greater return.

So the extra element Marks’s graph is showing is that, for each point estimate of return, there is a bell-shaped distribution of what those returns might look like. Thus, as you move to the right, not only does the expected return increase – as with the first graph – but the range of possible outcomes becomes wider and, importantly, the less good possible outcomes become worse.

This is “the essence of investment risk”, says Marks, adding: “Riskier investments are ones where the investor is less secure regarding the eventual outcomes and faces the possibility of faring worse than those who stick to safer investments, and even of losing money. These investments are undertaken because the expected return is higher. But things may happen other than that which is hoped for.

“Some of the possibilities are superior to the expected return, but others are decidedly unattractive.” The graph is, in other words, a good illustration – literally so – of the great line by London Business School professor Elroy Dimson that “Risk means more things can happen than will happen” and, as such, is a proper Lesson 1.01 for investors.

Author

Jamie Lowry

Jamie Lowry

Fund Manager, Equity Value

I joined Schroders in 2004 as an equity analyst in the European Equity Team initially specializing in the Industrial sectors before moving on to Consumer-based companies and finally Insurance. In 2007, I became a co-manager on a fund investing in undervalued European companies and took on sole responsibility for the fund in May 2010. Prior to joining Schroders, I worked at Hedley & Co Stockbrokers and Deutsche Asset Management as a trainee analyst.

Important Information:

The views and opinions displayed are those of Ian Kelly, Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans and Simon Adler, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated. They do not necessarily represent views expressed or reflected in other Schroders' communications, strategies or funds. The Team has expressed its own views and opinions on this website and these may change.

This article is intended to be for information purposes only and it is not intended as promotional material in any respect. Reliance should not be placed on the views and information on the website when taking individual investment and/or strategic decisions. Nothing in this article should be construed as advice. The sectors/securities shown above are for illustrative purposes only and are not to be considered a recommendation to buy/sell.

Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.