Investing principle 2: Accept that risk and return go hand in hand

Investing principle 2: Accept that risk and return go hand in hand

One of the inescapable truths of investing is that to achieve higher returns, you have to take on more risk¹.  That seems logical enough, but you would be surprised just how many investors seem to think that it is possible to get high returns with low risk. Yet risk should not be feared, because when appropriate risks are taken, they are the source of returns that investors seek.

Investors may get lured in by the bright lights of historical low-risk and strong returns. This type of ex post measurement can be a biased measure of ex ante (i.e. forward-looking) risk. Take one example: in the 1950s Mexico pegged their currency (the peso) to the US Dollar. This went on until August 1976. There was a large gap in the interest rates offered on deposits in Mexico vs those offered in the US. In effect, a US citizen could place their deposits with a Mexican bank for a – seemingly risk-free – higher rate, knowing that they could convert the deposit back to US Dollars with no effect, given the exchange rate was pegged. Mexico removed the peg to the dollar, and the currency – almost immediately – devalued by nearly 50%, sparking a financial crisis². The inherent risk was always priced in.

Risk and return go hand in hand

The ‘peso problem’ is a term that can be used to refer to a phenomenon whereby there exists an apparent and significant risk-free opportunity. The fact is that the higher return is usually on offer because the risks are greater. When these risks come to pass, investors get stung. 

One would have thought that, by now, investors would be able to grasp the concept that risk and return are reasonably well related. Unfortunately, 1994 saw Mexico go through a similar event but this time with more severe effects for Mexico’s economy, which was aided by US and IMF bailout packages³. Any investors aiming to take advantage of this opportunity would have been hit hard. Humans are generally terrible investors!

The one thing we know for sure about risk is that if an investment looks too good to be true, it probably is. If you ever see such an opportunity, you need to establish what the hidden risk is as you have not spotted it. Risk and reward are always related.

¹Sharpe, William F. (1964). ‘Capital asset prices: A theory of market equilibrium under conditions of risk’, Journal of Finance, 19 (3), pp. 425-442.

²https://en.wikipedia.org/wiki/Peso_problem_(finance)

³Maarten van der Molen, (Sep 19th 2013). ‘The Tequila Crisis in 1994’. https://economics.rabobank.. Accessed 14th Jan 2022