“Investing is a problem that has been solved,” Dave Nadig, managing director of ETF.com, likes to say. Keep it simple, hold down costs, diversify, invest for the long run and let the magic of compounding work for you. For most investors and money managers, statistically speaking, it is a high-probability solution.
Despite this, more and more people seem to be ignoring those investor-friendly moves. Instead, they have been embracing higher-risk strategies that hold out the theoretical possibility of higher — and in some cases, much higher — returns. Among the approaches: using leverage, buying farmland or timber acreage, betting on commodities and buying into private-equity and venture-capital funds.
What is behind the new appetite of risk? Let’s consider a few possible culprits:
No. 1. Lower expected returns: Markets are not predictable, but valuations provide broad guidelines about reasonable future return expectations. Traditional measures suggest U.S. stocks are fully or even richly valued; U.S. Treasuries and corporate bonds are offering some of the lowest yields in the postwar era. More than a decade after markets bottomed in 2009, and years after the end of monetary stimulus, there simply are fewer bargains and cheap stocks than there were.
My takeaway from this: investors should ratchet back their expectations of future returns. Clearly, that’s not a popular view and many reject it. Rather than accept more modest gains in the future — say, 2% for bonds and 5% for equities — some participants seem intent on juicing their returns by taking on more risk.
No. 2. Misunderstanding risk: Investors occasionally forget the definition of risk, which can be summed up as the possibility that the actual returns on an investment will be less than the expected returns.
Risk and reward are two sides of the same coin; to have a chance to generate higher returns requires accepting greater risk. Better performance comes with the possibility of worse performance.
Investors occasionally forget that risk is risky.
And in the pursuit of alpha (market-beating performance) many investors forsake beta (market-matching performance) and end up underperforming a benchmark or generating losses. That’s why high-return, low-probability bets have lots of risk and slim odds of reward.