A common saying which we all must have read during our school days is “no pain, no gain”. This simply implies that one needs to get out of one’s comfort zone to gain big. Investment is no different. A fairly popular investment technique which ages back to the medieval times of the European explorers is “higher risk, higher reward”. European explorers would take huge risks by sailing off to unknown land for months with no guarantee of success. But such risks were rewarded handsomely. Be it the gold of the Aztecs or the vast, mineral rich American land.
One of the key mantras of investment is diversification. This brings us to the juncture of the risk-taking ability. A key tenet of a good portfolio is investing in multiple avenues. The phrase higher risk, higher reward is generally how we split our investment between the riskiest assets such as equity and low-risk assets such as bonds and cash or gold.
The risk-taking ability also depends on the stage of life the investor is in. A senior citizen who lives on his pension wouldn’t want to risk his hard-earned savings in volatile stocks. A blue-chip, regular dividend paying stock would be the maximum risk that he could take.
Even before we consider investment, we must look at basic human needs. Maslow’s Pyramid places physiological and safety needs at the bottom of the pyramid. Money-wise it means that one must have enough saved to survive for a few months and have enough safety net such as term insurance or a health insurance. Human beings then move towards esteem needs and self-actualization needs. These needs in terms of investments are the higher risks that we take to get higher rewards.
Diving deeper into the topic, we realize that risk is a factor of volatility. The probability of an outcome to take values from the farther ends of the continuum makes it volatile. Volatility is rewarded if you are on the right side of the things. The famous Black and Scholes model which is used to price options rewards volatility with higher option premium. It simply means that if the underlying assets have the ability to acquire a value which is far away from its current value, the option to acquire it must also be expensive.
But again, things are not so straight forward. A recent study from the Investment Management firm GMO has revealed the plain old higher risk, higher reward strategy can have flaws. This is also due to the misclassification of the asset under a certain risk category. A particular asset might have a lower upside potential and higher downside risk and still be called risky. Taking the stock returns of over 30 years of investments in higher and lower risk stocks in the US market, the firm found that first quartile of the riskier stocks produced only 7% returns on an average, while the fourth quartile, i.e. the least risky stocks gave around 10% returns to the investors. This is a result of the shift of the trading philosophy of the institutional investors to stay as close as possible to the index returns. As a result, the volatile stocks which are a part of the index will result in fairly low returns.
Since risk is completely dependent on the individual, one must calibrate before taking a blanket approach towards a risk-taking strategy. While the majority of the investors try to reduce risk by diversifying in equities, they must also consider other avenues such as bonds or gold. But then, those risky bets are what give you exceptional returns. No one became a millionaire by diversifying.