Considering Risk and Return in Your Investments
When you borrow money from a bank, they require you to pay it back over a certain time period. They also require you to pay interest, the amount over and above the principal that you borrowed. The bank expects the interest to exceed inflation, cover any costs of servicing the loan, and make a little profit.
You are an investment for the bank. They invest in your ability to pay them back plus interest. The interest is their return. Your interest rate will depend on their assessment of your creditworthiness. If they deem that you are a good credit risk (ie, low risk), they will give you a low rate (ie, low return for the bank). If you are seen as a high credit risk, you will be charged a high rate.
This balance between risk and return is the entire basis of modern portfolio theory (MPT) and upholds the underpinnings of every investment made, by the bank, by hedge fund managers, and by you. However, just because Warren Buffett uses MPT when making investment decisions does not mean that it is too complicated or too difficult for you and your investments.
Yes, the underlying mathematical formulas are not simple. Harry Markowitz, Merton Miller and William Sharpe did not win the Nobel Prize for strolling in the park, but you do not need a degree in economics or finance to benefit from their award winning findings.
All assets have the same characteristics: risk and return. They also tend to have some correlation to each other, meaning if one particular assets changes in price, another asset will change in price as well, sometimes more, sometime less, and sometimes in the opposite direction (negative correlation).
The degree to which an asset fluctuates is called standard deviation. The higher the standard deviation, the greater the fluctuations are likely to be. If you do not like to see your portfolio move from great highs to great lows and back again over short periods of time, you would prefer to have your standard deviation as low as possible while your portfolio is growing at the highest rate possible.
By combining assets with low correlations into a portfolio, you can offset some of the risk in the riskier assets while still maintaining a higher return. The Nobel Prize was given for discovering the “efficient frontier” – that line along which a combination of assets can give you the best return for the lowest risk.
The problem with investing along the “efficient frontier” is that correlations are all based on historic performance, which if you have spent anytime listening to investment shows or reading about different assets, you will know that “historic performance is not predictive of future performance.”
So what now? Did I just lead you in a giant circle? Yes and no. Trying to build a portfolio of individual securities along the efficient frontier would be a useless statistical exercise because the volume of data that is constantly shifting would make it impossible to keep your portfolio on that frontier for any lengthy period of time.
Imagine trying to bake a cake by selecting just the appropriate number of sugar crystals and flour specs. It would take forever and would not yield a better cake than following the recipe by taking one cup of sugar and two cups of flour.
Basically, that is what your portfolio is, a recipe made to your taste, with each asset class representing a different ingredient. You can build your portfolio by selecting a certain percentage in each class, such as stocks, bonds and cash, to match your circumstances such as age, risk tolerance, etc.
