Tuesday, November 27, 2007

Risk and Return

In my previous posts, I've been shooting returns like 2% p.a., 5% p.a. Some people said that 8% returns is the minimum you should get. Some said 25% p.a. is the norm. If you do have friends who said that this is the norm, ask them the return now. Most probably they will not give you a straight answer because the market has not been doing well since the sub-prime crisis in the United States.

The higher risk you take, the more rewards that you should get (not will). This is the basis of investment. Most of us like to put our savings in our bank savings account, or Fixed Deposits (FDs). The reason is because it is quite safe. We're almost guaranteed to get back our money, plus the interest. Therefore, since the risk is low, we get obscenely low returns like 0.25% and 1.2% (Artificially low in my opinion).

However, if you want higher returns, the first question you need to ask yourself is are you willing to take the risk that you might lose money in the short run, but get your returns in the long run? That means staying put even though you might lose 20% of your investment, with the strong belief that everything will be right in 20 years time.

If you cannot bear losing that amount, then I would suggest that you should continue parking your money in FDs, saving accounts, and Treasury bills (T-Bills). Safest in Singapore. More likely you can only invest in one other option. Your job. Invest in it well, and you'll be paid better (hopefully).

If you think that you can stomach the 20% loss (Be truthful), then I would believe you're suited for investments in the different asset classes I mentioned in the previous post.

Why would people actually take such risks if you could lose 20% or more of your investment?

Main reason is because of the fundamental belief that over the long run, the market will be always a line that is sloping upwards. It will have some volatility but over 20-30 years, it will smoothen out, and the end result is that you will get your returns. Just imagine what Singapore was like in 1965, and now in 2007. 42 years and we've grown so much. That's the basis of this belief.

However, even though you could lose 20%, that doesn't mean that you have to. That is diversification, as mentioned in my previous post. Take a right balance of asset classes, with the risky assets and the safer assets. In the end, your returns are lower (still higher than FDs), due to lower risk, but your retirement portfolio will be growing steadily. This group of people most probably will be looking at the sharpe ratio more. In general, the higher the sharpe ratio, the better the risk adjusted returns you will have.

Some people likewise practice Focus Investing, which is the opposite of diversifcation. The basis is you focus your investments on the companies that you think will give the most returns, and invest in it big time. The most famous of them all is Warren Buffett. Coca Cola? MacDonald anyone? This relies on you making the right "bet", and getting it right. However, we usually only know about the winners, but not the losers. Focus investing is very risky because you stand the chance of losing everything. This group of investors focus alot on the alpha and beta of the company, especially on high alpha companies. In general, beta means the level of influence that the market has on the company. Alpha means the movement that is independent of the market. This is also known as systematic and non-systematic risks.

This post is not really about saying what's the risks vs returns graph, alpha and beta, or sharpe ratio. You notice that I've mentioned quite a few terms, but giving only a brief summary. Reason is that there are many books or websites out there that focuses on these definitions. I think they would do a better job than me explaining it in my small little post. This post is more about understanding the concept that there's no free lunch. If someone is giving you a high return, you're taking a higher risk.

There's also a misconception that index funds, or ETFs are very low risk investments and you can plonk your whole fortune in it. That's in-correct. Let's say you have invested in the Singapore Index when it's at a high of 3800. Now the index is at 3300. How much would you have lost?

Asset Allocation is what matters in index investing, and that's what keeping the risk low for index investing. I'll be talking about it in my next retirement planning series.

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