Everybody accepts that risk and reward are two critical parts of investing, but do we really understand the equation and are we managing it properly within our investment portfolios?
In the first sense it is exactly what it says, if your potential reward is high then equally your potential risk must also be high. We understand this, but we often do not really take cognisance of the actual risk. So we find a small-cap stock that looks like it could shoot the lights out and put some of our hard-earned cash into the stock. Then, instead of performing well, it collapses into a heap losing say 90% of its value. A few things have happened here, the obvious being a destruction of great wealth, but there is something even more important that we fail to fully understand. Say we invested R5 000 into the stock, a 90% loss means our investment is now worth a very modest R500. The reality is that in order to get back to breakeven, we need the current price to improve tenfold. In other words, if this stock does a tenbagger on us, we’re merely at breakeven. What are the real odds of that ten-bagger? I would suggest close to zero.
So it is more than just risk versus reward, it is also about recouping that loss if the risk side of the equation plays out.
Another issue is why we swing for the fences taking extremely risky positions – we’re trying to get rich in a hurry. So let’s look at that side: your investment increases in value tenfold and – a real tenbagger. Your R5 000 ramps upwards and becomes worth R50 000. That’s great, but is it life-changing? That amount could buy you a great weekend away, but you’re certainly not retiring early on a mere R50 000. The point here is that while the actual reward is absolutely attractive, it is not life changing, yet a string of losses could be ruinous. Sure, we could do a bunch of ten-baggers in a row, then things would be different but that’s never the case.
So we go out on a limb with real downside risk and while we focus on the reward, we forget the implications of the risk. For example, if it took us a year to save that R5 000 then we’re now a year behind in our investment strategy and potentially retiring a year later.
If the R5 000 had been invested into an exchange-traded fund averaging a decent 18% per year return that money, would double in value every four years. Sure, you’re not getting rich in a hurry but this can be life changing in time. Imagine adding R5 000 every year and seeing it double every four years? After a decade you have invested R50 000 (a decent amount by any metric) and if it all grew at 18% a year, you would have a portfolio of almost R140 000! Now we’re talking and you’re only investing R5 000 a year ( just over R400 per month). In other words, without shooting for the stars and without taking onboard serious risk, you are creating real wealth.
If we carry on with the above example, investing R5 000 per year and growing it by 18% a year, after 20 years the portfolio is some R865 000. After 30 years we’re almost at R4.7m and after 40 years the value is almost R25m! Of course inf lation has eroded the value of that R25m, but the R5 000 you started with is now just small change.
The bigger picture is that we do not need insane risk if we give ourselves time. The person going for high risk may have a few winners but, in truth, has had a lot more bust-outs and probably has a portfolio that is close to nothing while opting for the more long-term option with lower risk has reaped real wealth.