Shanghai Evans Investment Management Limited

Article 3: Understanding risk and return

Introduction

This is our third Article and looks at the two key components of investing: risk and return. This is something we introduced in the first column as part of a broader overview. Now, we will focus on it in more detail so we can better apply it in our investing decisions. I want to avoid putting a great amount of mathematics into these columns. However, finance is a quantitative subject and it is not possible to avoid ‘the numbers’ completely. However, I will focus on more simple examples to illustrate the important underlying concepts and not get into great detail about variations on these concepts. It is always good to start with some definitions.

Return: in investing, return is the gain or loss we get over time by holding an investment. We often talk about return as a percentage and on a per annum (per year) basis. As an example, we find over the last 100 years that large stock market returns were about 10.0% per annum. Since we are looking at the future in investing, we are looking at ‘expected returns’ (as they have not happened yet).

Risk: since we are looking into the future and trying to predict returns there is always a risk our forecast could be wrong (uncertainty about future, expected returns). We often try to estimate our risk (forecast uncertainty) by looking at the variability of returns for that asset in the past (standard deviation of historical returns). So, looking below at our ‘large stocks’, though they went up in value by 10.0% p.a. on average – we see that returns for any particular year might have been very different. If we look at a longer period of time, for most years, large stocks might have gone up about 30.0% (10.0 + 20.6) but in other years you could have lost 10.0% (10.0 – 20.6). This is a bit of a simplification but still is a valid representation of the general concept.

You see two average values in the above chart, geometric mean and arithmetic mean. For multiple years we use the geometric mean as it reflects compounding of returns. We only use the arithmetic mean when looking at a single, hypothetical year. So, geometric mean is our return and standard deviation is our risk.

In the above chart, the four asset classes are listed from most risky at the top to least risky at the bottom (ignore the 5 th category of inflation, an economic variable, for the moment). From this we see one of the most important relationships in finance: the risk – return trade-off. This trade-off says that if you invest in assets that have historically had a higher return (large stocks had a higher return than longterm government bonds) then, by definition, your investment has a higher risk. One of the most important investment decisions is choosing the investment asset that has the correct risk – return tradeoff for your unique investment circumstances.

The below graphic is a good illustration of this relationship. Let us imagine the return distribution on the left is for T-bills (short term government debt). Its historical return is the lowest – the lowest point on the line as measured on the vertical axis. But we also see that the variability of its returns, as illustrated by the distribution superimposed on the line, is the smallest. The second asset from the left might be government bonds and its historical return is higher than T-bills but its distribution is also ‘wider’, meaning greater variability – risk. The third from the left is large stocks and the one to the right is small stocks. Again, with more return comes greater variability in returns in any given year.

Investing and inflation risk

Let us look at the 5 th listing, the economic indicator of ‘inflation’. Inflation is the annual decline in value of your money. I won’t go in-depth in discussing it but just focus on its impact on investing. When you invest, you are interested in knowing what your real economic return is. If you earn 3.8% on a T-bill but inflation is 3.1%, your net economic return is 0.7% for that year. Inflation reduces the economic return of your investment – and all investments because your money is worth less.

Some people might look at inflation and say a 0.7% return is too low for them and so ‘move up an asset class’ to, say, large stocks because they have a higher expected return after inflation. That may be true, but you have also moved into a different investment asset (stocks vs. T-bills) and you have taken on a higher level of risk, which might not be appropriate for you. One must always remember that by moving into an investment with a higher expected return you are taking on more risk.

Risk and time

In a future column, we will look in detail at ‘life-cycle investing’ and will see how important the planning time horizon is for investment decisions. But we will look at it briefly here to introduce this important concept and highlight it with a small case study, to follow.

I have no doubt that most will agree that ‘time is good’. More time means a longer life, more time to do the things you want to do, more time to grow your business, more time with the family, etc. But time is also ‘good’ in investing as it allows us to achieve a higher investment return over a longer time period. This is because investment returns have (almost) always run in cycles. So, the stock market might have lost value last year (the Shanghai Stock Exchange lost about 25% in 2018) but a large and strong economy giving a profitable base for companies, one would expect the SSE to increase in value in future years, we just do not precisely know when. But, if you have no short-term pressure to cash in your investments then you have the time to wait until the stock market is higher again, sell at those much higher levels and achieve that higher stock market return.

Case Discussion – time and investing

Consider the case of an individual with a one-year investment time horizon. The time is January 2019.

Individual 1: has money to invest but needs all the money at the end of the year to buy a home he committed to buy. The house costs CNY 1,000,000 and he can borrow 600,000 – thus he needs to provide 400,000 of his own money. Right now he has about 388,000, so he needs some investment return to make up for the 12,000 deficit.

One investment alternative is to put his 388,000 in a China government 10-year bond currently yielding 3.15%. This has good liquidity and so he will have little difficulty cashing out at the end of the year. Though government bonds don’t have a guaranteed investment return, a 3.15% return will just allow him to meet his investment target. He also believes that because the China economy is weakening there is little chance that interest rates will rise in 2019 and so he will not suffer any capital loss on his investment, he might even get a capital gain if interest rates decline further.

He also considers the stock market, as a return of 3.15% sounds quite low and can he do better and earn a surplus for his investment with stocks? He consults his Financial Advisor who says that due to uncertainty in the world there is a 50% chance the SEE will go up 20.0% but also a 50% chance that the SEE will go down 10.0%.

Recommendation: the investment objective here is not to earn the highest possible return but rather to achieve an increase of 12,000 so that he has adequate money to buy his house at the end of the year. If he were to get more that would be great, but if he did not earn enough to pay for the house that would be viewed as a terrible personal mistake. In this circumstance, the Financial Adviser would advise him to invest in the government bond. There is a very low risk that it will not earn the 3.15% and guarantee him enough money to buy the house. Conversely, there is a high risk (50.0%) that the stock market will lose value and he will not have enough money to meet his investment goal.

If he was not planning to buy the house for three years, and needed to earn a higher rate of return, then there would be a stronger argument for investing in the stock market, for over a longer period, here three years, it greatly increases the probability of having a high return year when he can cash out of the market to protect his capital. From this very simple example, we can see that your investment time horizon and goal plays an important role in what sort of risk one can accept. The more time you have, the more you can invest in risky investments and earn the higher return that comes – over time – with those more risky investments.

*****

“Understanding the trade-off between risk and return is essential in investing. Understanding how time influences that trade-off is also vital”.

John D. Evans, CFA (author) has over 24 years’ experience in the international capital markets working with issuers of securities and investors around the world. He has designed and taught Master’s programmes in investment management at universities in the UK and China. He was most recently Professor of Investment Management at XJTLU in Suzhou. He now manages SEIML, a consultancy to early-stage companies in China.

Jina Zhu (translator) did her Master’s in Economics in France and is fluent in Mandarin, English and French. She also works at SEIML supporting early-stage companies grow and raise capital in China.

15 February 2019