The Relationship Between Risk and Return
Journalists have a tendency to talk about a sudden stock-market decline as if it was an emergency. Even the Financial Times has reported a ‘fresh collapse for global equities’ . The tone of this reporting activates our natural fight-or-flight response; emergencies, shout our hormones, require swift action. That response is very helpful to a herd of wildebeest when the emergency is the arrival of a lion. It is extremely unhelpful to investors. In the twenty years to December 2013, for example, the American stock market returned 484%, while the average investor in American equity funds achieved only 166% , having consistently bought high and sold low. Our emotions tell us to do the wrong thing, and following their siren song is extremely dangerous to our wealth.
The reality is that, far from fearing declines in price, we should positively welcome short-term volatility in the markets. To explain why, let us take a short detour into economic theory. Economists understand the market as setting the price of shares on the basis of a ‘risk premium’. The idea is relatively simple. Imagine that you analysed a company and made a reasonable forecast of its profits, out into the distant future. Having done the analysis, how much would you pay for the whole company? Would you, for example, pay so much that that stream of profits would give a return on your money of 2% a year? You probably would not pay that much (even though 2% a year is much better than the current rate on cash), and nor would anybody else. The reason is that investing in companies is risky: the future stream of profits might well be less than you expect, and the company might therefore fall in value. You probably would not even consider buying the company unless the price was much lower. An economist would say that you are ‘pricing’ the company to return more than 2%. The difference between the return you are prepared to accept and the rate you get on cash is the ‘risk premium’ – the extra return you have demanded for taking on the risk of owning the company rather than leaving your money in the bank.
Stock markets are prone to the kind of swing that has just occurred. In 2011, concerns about global growth and tightening monetary policy (and the debate about the debt ceiling in the American Congress) saw the FTSE 100 down almost 22% from its previous peak by early August . In 2010, the FTSE fell 18% between April and June . And of course the index fell much further during the global financial crisis of 2008-09. Because such episodes are common, and because investors fear them, a risk premium is priced into global equity markets. Because a risk premium is priced in, patient investors can achieve high returns, on average, over the long run. That is why we should not feel too bad about volatile times: if there were no volatile times, equities would not be risky, and would therefore not be priced to give good returns.
If other investors fear market declines, then why should we not? There are two kinds of fear: rational and irrational. As we have seen, some private investors may have an irrational fear of market declines, and we should not follow their example! Institutional investors may have more rational fears. Pension fund managers, for example, might be fired if their returns do not meet what is needed. Managers of sovereign wealth funds or currency reserves can face political fallout if they ‘lose’ money in the short term. Banks, which fund their assets with massive amounts of debt, can become insolvent if the value of their assets falls. In contrast, as long as his or her long-term plan remains on track, a private investor can ignore the kerfuffle and wait for markets to recover, if necessary for several years.
Everyone knows that equity markets are volatile; but it is also true that they should be expected to give good returns over the long term. The trick is to get to the long term by holding through the short term. The right response to the latest ‘emergency’ is to realise that it is not an emergency at all, but a perfectly normal sell-off of the kind that happens every few years. Could it become a worse decline, of the kind that happens every decade or so? Of course, that is possible – but it would still be perfectly normal. Each one of our clients has a portfolio with a risk profile that is appropriate for them and for their long-term plans. They will be well-placed to ride out these normal events, with confidence that they are taking reasonable risks in the hope and expectation of good long-term returns.
John Butters CFA, Chartered MCSI
Head of Investment