Monday, July 30, 2012

The big question: Risk vs Return, Part 1

Everyone loves higher returns. At least I assume so. All else given, I'd much prefer my money grows at 1000% compared to 100% annually. OK, I'm dreaming.

But still, everyone loves higher returns. So where do they come from? Investments. Let's start from the highest return.

  1. You start a company! Yes, if you start a company, your expected return will be huge. Let's see, Bill Gates, Larry Ellison, Mark Zuckerberg, Larry Page, etc... Just take these people as an example, they probably have 30 billion dollars each, so there's your 120 billion dollars. If they started with a combined total of 100k, then it's more than 1 million times in return! Even taking people who fail when starting up their own company, the average return is probably still well over 100 times. That's 10000% return in probably 20 years, a mouth-watering yearly average of 26%. Considering increasing the return by even 5 percentage points over the average of 8% is considered a major feat, this rate of return is simply astonishing. Now clearly, we don't see people flocking to start their own companies, why? Mostly because it's risky! Of all entrepreneurs, maybe 5% will succeed with millions in 20 years, 90% will fail with no return, and 5% probably will keep their investments. (I'm making numbers up here, but I'd say it's an educated guess) We must understand that for an average person, the pain of losing 1 million dollars is much greater than the joy of making 1 million dollars if they had 1 million to start with. Of course, other factors such as higher time / energy devotion required for one's own business may also play a part. 
  2. Equities. If we ignore the characteristics of derivatives such as leveraged funds, futures, options and the like, for the period of 1926 to 2011, the broad stock market, each individual stock weighted by their market value, had an annual return of 9.9%. A really high number. To put this into context, in 30 years, your portfolio is expected to grow by 16 time. I.e. what was 10k will become 170k. And the down side is that stocks are very volatile, meaning that their prices vary a lot from year to year. The worst year for 100% stocks was 1931, a year where the broad stock market dropped 43%. Take a moment and just imagine if all your savings, probably 100k, is now only 57k, in just a year! Ouch. What's more, in 25 years out of those 86, almost 30% of the entire duration, you'll end up with some kind of loss. Imagine the psychological effect it might have on you, a lot of people are not willing to bear this psychological pain, or they do not have enough time to wait for the market to "come back to normal". 
  3. Bonds. Bonds have risks too. You can get defaults and interest variations. But bond risks are significantly lower: for the same historical period of 1926 to 2011, the absolutely worst year for bonds were -8.1% in 1969. In other words, in almost 100 years, investors would have never lost more than a tenth of their investment had they gone for diversified bonds only. A price had to be paid to the low risk though, in this case a much lower return of 5.6% annually, not even two thirds of what equities can provide you with.
  4. Cash or cash equivalent (CDs). Now these have almost zero risk. All bank deposits in the U.S. are insured by FDIC for up to 250k. So essentially they are completely "safe".  I wasn't able to gather historical data back to 1926, but we currently have an average deposit interest rate of below 1%. 
The general trend is clear, higher risk, higher return. This may not hold true for short periods of time though, and "short" can actually be fairly long. For example, since the early 1980s, where interest rate was at sky-high 20%+, bond yield has kept dropping steadily, which created the biggest bond bull market. Therefore, for the most recent 30 years, bonds actually offered higher returns than stocks. But since interest rate can not  decrease forever (there is this magic number called zero), the potential gains from bonds will be limited. And personally I think over another 10 or 20 years, bond returns will come back to the normal 5% ish range. 

Personally I think this post has been rather chaotic, as I tried to take on too many things in a single post. I guess on the next post I'll start with just stock, and hopefully discuss risk involved in some depth when it comes to stocks. 

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