Risks Without Returns

The risk/return principle asserts that returns and risk rise together. But what when they don't? Is there a way to protect yourself against risky investments that never deliver?

Risk in the financial markets is usually associated with uncertainty of outcome. When the price of an asset fluctuates like a yoyo it's hard to predict future returns.

It's easy with a fixed deposit. If an effective rate of 5% is on offer, you know with almost complete certainly that at the end of the year your R100,000 will be worth R105,000. In the stock market, prices next year could be higher than they are now or lower. Who knows?

Volatility is used in the financial markets to measure price variation.

A fixed deposit has a volatility of zero. Resource funds currently have annualised volatility of 16% to 33%. This can be crudely interpreted to mean that the "normal" price variability of resource funds is between 16% to 33% a year (where "normal" means it could be greater under abnormal circumstances). So your resource fund could go up or down 30% in the next year and that wouldn't be particularly unusual for the sector.

Bang For Your Buck

Of course, resource funds sometimes give great returns. The JSE Resi 10 has doubled since its low in January 2016. But to put this in perspective, in the 18 months before that it lost 60% of its value. This is the nature of high volatility.

Investors with an appetite for resource funds usually have faith in the resilience of the commodity cycle. In other words, they're confident resources will always bounce back – one just has to be patient.

we have to be careful which risk assets we bank on – the wrong choices can leave us with all the negative consequences of risk and none of the payoffs

For the most part, this is true, although resources can certainly hurt your portfolio if you get the timing wrong. Still, the commodity cycle mostly lives up to the idea that price uncertainty is rewarded if you're able to hang in.

US stock markets, looked at through the lens of the S&P500, have also delivered on the risk/return proposition. Market shocks, the crashes of 1987, 2001 and 2008, have proved to be only temporary setbacks in a growth trajectory that now goes back over a century.

But this is not always the case. There are all too many examples of high-risk investments that have not rewarded investors.

Low Performing Risky Investments

Silver is a good example of a volatile investment that, on the whole, hasn't delivered.

By the end of the first world war silver was trading at around one dollar an ounce, having doubled from $0.51 in 1915. In 1932 it sank to $0.28 and it wasn't till 1961 that it got back to one dollar. WW1 buyers had to wait 40 years; by then the mighty dollar wasn't what it had been.

Since 1961 there have been two silver market bubbles that saw the price go as high as $48 an ounce, but it's recent average is about $16. And here's the rub – adjusted for inflation, a 1918 dollar is the equivalent of around $16 today. Unless you bought at one of the market low points, silver has delivered zero investment growth in real terms over the last century. Even if you caught the exact bottom in, say, 1931 or 1971, your annual returns are poor if measured up to 2019.

Of course, you would have done well had you sold when silver spiked, but the average investor is more likely to have been drawn into the silver mania at the worst time than to have been selling silver bought a few years before. And in both bubbles, the windows of opportunity were quite short-lived.

A further comparison with the S&P500 is apposite. If, for example, you had bought the S&P500 at the worst possible time in 2007, just before the crash, you would nevertheless be over 100% up today (with dividends). If you'd bought silver at the worst possible time in 2011, your investment is only worth 40% of what it was then (even though the silver price is comparatively strong at the moment).

This is not to say that all stock markets are safe.

The Nikkei 225, an index of the Tokyo Stock Exchange, reached a peak at the end of 1989 (that's 30 years ago) which – so far at least – it has never surpassed. Having never really recouped more than half its losses, it fell again after the 2008 crash to levels representing just 20% of its peak value. In spite of a strong recovery since 2012 the Nikkei is still nearly 50% off its 1989 high.

And The Moral Of The Story Is...

What can we learn from these examples?

Investors are frequently advised that they need to take on some risk if they want to get superior returns.

The point of these stories is to illustrate that we have to be careful which risk assets we bank on – the wrong choices can leave us with all the negative consequences of risk and none of the payoffs.

Our own JSE is a pertinent example. In early 2015 the Top 40 index had an annualised volatility of around 11%, which placed it on the risky side of the asset continuum. But investors who took on the risk of price uncertainty in the equity markets in the hope of capital gains have not been rewarded – our whipsaw market means that volatility has actually increased while the index is back where it was.

It is not easy to protect against such risks. If it was simple to identify which risk assets to avoid then risky assets would not be, well, unpredictable – which is the heart of the problem.

There are, however, a few things investors can do to protect themselves.

Diversification, as Markowitz said, is the only free lunch. Diversification needs to be applied across sectors, currencies and countries.

Crazy valuations are a warning sign which investors ignore at their peril. The average P/E on the Tokyo Stock Exchange in early 1989 was 58. There were scholarly articles about why those valuations were nothing to worry about, just as there were articles during the tech bubble saying old-fashioned metrics like P/Es were no longer valid. Tokyo and tech stocks crashed.

Fundamentals should never be ignored. If the economic or business fundamentals don't support the valuations, tread cautiously.

Forecasters are best ignored. The consensus forecasts at the end of 1989 saw Tokyo stocks rising to new heights in 1990 – in spite of the huge P/Es being commanded. We all know what happened next.

¹If you invested in October 2013, when the Resi 10 appeared to have resumed an upward trend, the 100% gain in the last few years doesn't mean much, you're still 15% below where you started.