One of the most important relationships in modern finance is the risk-return relationship as defined by the Modern Portfolio Theory propounded by Harry Markowitz in 1952 in Journal of Finance. According to this theory, as the expected return from an asset class or instrument increases, the risk also rises, i.e., a high return instrument will carry high risk and vice versa. An investor can reduce the overall portfolio risk by diversifying across instruments or asset classes. The fundamental underlying principle of this theory is that markets are always efficient and it is almost impossible to find anything investible that has low risk and high return. But if one looks at the real world, does this relationship hold up? If it were true, then the most successful investor would be the one taking the highest risk. But we know it is the reverse. Almost all successful investors, and successful businessmen too, are highly risk averse. They give topmost priority to protecting capital, but that does not mean that they generate low returns. On the other hand, those taking high risks repeatedly end up going bankrupt.
So, how do these investors make superior returns with low risk. The answer possibly lies in these two important variables:
1. the price you pay for acquiring the asset, and
2. the time period for which you hold the asset.
Let's talk about both of them in detail.
Price of acquisition
Everything is right at the right price, goes a popular saying. While that might not be completely correct, the right price can make a huge difference to the returns and risk. My ex-boss, a well known investor, once said that an attractive price can make up for many other wrongs in a stock. So, if things go wrong, you don't lose much (as anyway expectations are very low), and if things go right, you win big. In other words, heads you win, tails you don't lose much. Benjamin Graham, the father of value investing, also termed this as "margin of safety".
In a study done on Nifty price-earning (P-E) ratios and subsequent 3-year returns, it was found that if you had invested in Nifty when it was at a P-E ratio of 14-16 (the lower end of its historical trading range), your average 3-year returns would have been around 110%. This high return does not come with higher risk as there are very few times (I can recall only 2-3 in past 15 years) when Nifty P-E has fallen below 10, and that too for not more than 6 months. So, buying at low price increases your chance of high returns at low risk.
Conversely, if you had invested in Nifty at a P-E of 22-24, your average 3-year returns would have been negative-15%, and with high probability of a P-E correction or market stagnation. So, buying an asset at high prices lowers the return while also raising the possibility of loss. Mind you, this is the same asset in both cases.
So, the current prevalent selling pitch that you will make 12-15% returns in equities over 3 years, irrespective of index level, needs to be taken with a pinch of salt.
The same principle holds true for debt instruments, though the price fluctuations might be lower. In debt, the return is capped by the coupon rate and market price, while the risk is theoretically infinite (in case of default). So, for retail investors, the most important thing, and possibly the only factor to look for in a debt fund, is the rating of the instruments.
While fund managers might look to be in the top-performing funds by buying lower-quality bonds, the extra return to investors is just not worth the extra risk.
The holding period
Bill Gates says that we overestimate what we can achieve in 1 year and underestimate what we can achieve in 10 years. Taking an investing analogy, we possibly give too much importance to short-term price movements and low importance to longer-term trends. In other words, we confuse volatility with risk. Risk is the permanent loss of capital while volatility is the change in price on a daily or short-term basis.
So, if you are buying a diversified equity instrument in a low and falling market, the risk over a 3-5-year period is very low, though near-term price risk will be high. Conversely, buying in a high and rising market might give good near-term returns but longer-term risk of loss of capital is also high. In debt also, if you hold an instrument till maturity, the interest rate risk will be zero.
We need to revisit our understanding of risk and return while investing in the real world. No instrument has a fixed risk-return profile, and the linear relationship between risk and return does not always hold. In fact, it possibly never holds true for market-traded instruments, as they either trade below or above their intrinsic value. Moreover, investors can use basic thumb rules or rudimentary research to get a broad idea about the likely risk and returns at a particular point of time.
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