BMO Nesbitt Burns
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475 2nd Ave South, 3rd Floor
Saskatoon, SK
S7K 1P4

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 Risk and Reward

Risk. Some people are risk averse while others are comfortable as risk-takers. Yet without considering it much in our day-to-day lives, we surround ourselves with risk. Risk indeed has four letters, but does risk have to be a proverbial four-letter word when it comes to our investments? Not necessarily.

In 2002, in his book The Four Pillars of Investing, William Bernstein wrote "The history of the stock and bond markets shows that risk and reward are inextricably intertwined. Do not expect high returns without high risk. Do not expect safety without correspondingly low returns.” In the simplest language, any investment will involve some form of risk. But should we fear risk or should we embrace it? If we accept that risk is an integral part of the investment process, we can approach our investments more rationally.

Risk-free assets such as treasury bills (short-term promises to repay issued by a government) tend to offer the lowest rates of return. At the extreme, as a by-product of the recent investment environment, some risk-averse investors have even paid more than the future value of the government’s promise, guaranteeing themselves a small loss of capital. Generally, short-term treasury bill obligations have paid a real return of less than 1% per year; mid-term government bonds 2%; and the premium that investors demand for taking on the extra risk of owning equities averages about 6%. In the longer-term, you need risk-bearing assets to generate wealth.

Even for clients that are only interested in preserving their wealth, investing in only ‘risk-free’ assets will deplete their portfolio, as even these nominal rates of return are subject to taxation. Over time inflation will erode most of the earned income, which translates into reduced future purchasing power. Moreover, as governments add to their debt levels in an attempt to grease economic wheels, concerns grow – particularly for the US Treasury – about their ability to repay trillions of dollars in debts, leaving large holders of US debt and dollars concerned about their exposures to assets that have always been thought to be bullet-proof. A "risk-free” asset suddenly sounds like anything but, when there are potential repayment issues, the possibility of US dollars losing purchasing power versus other currencies, and rates of return net of taxation that are so trivial that they are all but guaranteed to lose to inflation in every period. It could indeed represent an impairment when trying to amass wealth.

So, having recognized that risk is not something avoidable but rather is something that can be addressed and hopefully mitigated, should it still be feared? Perhaps not feared, but certainly it should be respected. If we agree that we should be careful buyers of risk, where does the greatest potential for returns versus the level of risk undertaken lie?

Equity investments represent fractional ownership of a company, be it publicly traded or a private business. With each share owned out of the whole, the investor is entitled to that percentage of the profits, or losses, of the company, with most equities valued on the present value of all future cash flows. Equity investors are typically rewarded over the long term for their ownership through dividends and/or capital appreciation. Historically stocks have delivered greater returns than bonds and treasury bills because there is a greater risk attached to equity ownership, as we have certainly observed most recently.

Bad decisions made by a company are rarely borne by the debt-holders, excepting in the case of a bankruptcy; whereas an equity investor might take a substantial haircut in the stock price. Equity investors receive greater upside potential in exchange for taking on greater downside risk. Does the potential for extra return make the case for owning only equities and eschewing the lower return instruments? Generally speaking, the answer will be no. Why? The answer can be distilled into two words – risk and time.

Defining the risk inherent in any vehicle relies on the period over which you intend to own the asset. With a bond or other shorter-term obligation, your return is defined, as is the term of the investment. With equity you have purchased ownership ad infinitum, and over any long time period every company is likely to have a rough patch.

The current economic downturn provides an excellent case study. As little as one year ago, in the face of a housing bubble and a credit crunch, equity pricing remained near historic highs. With developing nations, in particular China, having nearly insatiable demands for materials, technology, and financing, equity valuations went even higher. With so many stocks priced for perfect corporate execution, the risk lay not in being under-invested but in holding stocks trading at high valuations relative to both their peers and their historical averages. Notwithstanding the extreme valuations, investors with both short and long term horizons were drawn to the equity market, as the dual forces of fear and greed took hold - the fear of never being able to buy stocks at these prices again and the greed represented by our desire for both long and short-term profits. With the subsequent market decline, one whose velocity eclipsed all other declines save the crashes of 1929 and 1987, investors forsook greed and gripped tightly to fear, as stocks prices descended to multiple year lows. Curiously, with the markets at all time highs the risk was brushed aside, but when stocks traded at the lows risk was the watchword, despite the stocks trading for a fraction of their previous values.

How then do we differentiate between real portfolio risk and our perception of the risk environment? No less of an authority on investing than Warren Buffett tells us to "be fearful when others are greedy, and greedy when others are fearful.” While seemingly simple in its objective, Mr. Buffett has three distinct advantages over most that allow him to execute on this mantra. His control over his corporate environment gives him the luxury of very long periods of time to let his ideas work out; his personal psychological make-up allows him to be comfortable making contrarian decisions; and he is, above all, an extremely wise investor. While greed and fear are natural phenomena not restricted to investing, applying them practically – moreover taking advantage of the greed and fear of others – can obviously lead to market-trumping returns.

The lessons to be learned from risk are all around us. In the search of a few percentage points of additional yield a plethora of mortgage buyers, banks, and brokerages were wiped out because they bought investments that few could understand and still fewer could price. Sadly, in part because those risks were not fully appreciated, equity investors everywhere have taken hits. Even those not looking for risk found risk looking for them.

We cannot avoid taking some level of risk in hopes of creating more for tomorrow than we have today, but understanding and controlling how we feel about risk, and controlling risk in our portfolios will undoubtedly lead to better results.