By ROBIN POWELL
A fundamental rule of investing is that risk and reward are related. If you like, they go hand in hand.
But let’s be clear: that doesn’t mean that the more risk you take, the higher your reward will be.
Sometimes risk and reward are positively correlated. Warren Buffett gave this example in an article he wrote in 1984 called The Superinvestors of Graham-and-Doddsville:
“If someone were to say to me, ‘I have here a six-shooter and I have slipped one cartridge into it. Why don’t you just spin it and pull it once? If you survive, I will give you $1 million.’ I would decline — perhaps stating that $1 million is not enough. Then he might offer me $5 million to pull the trigger twice — now that would be a positive correlation between risk and reward!”
But sometimes in investing, risk and reward are negatively correlated. In other words, the investor takes more risk and can expect a lower return as a result.
One risk you CAN’T eliminate
The first thing you need to know is that there are different types of risk. The second thing to understand is that there’s one type of risk that equity investors can’t do much about. It’s called market risk.
Markets don’t go up in a straight line. There are bound to be periods of volatility. Every now and again, markets will crash and it may take them many years to recover.
Yes, if you’re worried about a crash you can invest some of your money in a safer asset class such as cash or government bonds. That will reduce how much your portfolio falls in value when a crash in occurs.
But it won’t stop the equity element of your portfolio taking a substantial hit.
Market risk is serious stuff. It’s certainly shouldn’t be taken lightly.
Three risks you CAN eliminate
But some investors, it seems, are gluttons for punishment. These investors are called active investors. They invest in actively managed equity funds.
In addition to market risk, active investors take on three additional types of risk:
stock risk (i.e. the risk that the stocks in your fund fall further than the market as a whole);
style risk (i.e. the risk that the fund manager starts investing, like Neil Woodford did, in riskier (eg. very small or unlisted) stocks; and
manager risk (i.e. that the fund manager underperforms the market).
These are very real risks. For example, market returns are driven by only a tiny fraction of stocks; the chances of your fund manager identifying all of them, in advance, are very small.
As for manager risk, the word “risk” is in this context is misleading. Only around one per cent of fund managers outperform the market on a cost- and risk-adjusted basis over the very long term. The overwhelming likelihood is that, whichever active fund you choose today, it won’t be one of those very few winners.
In The Little Book of Common Sense Investing, the late Jack Bogle explained how stock risk, style risk and manager risk could all be eliminated by patiently investing in low-cost index funds — “owning the entire stock market (owning the haystack, as it were) and holding it forever”.
He went on: “Yet market risk remains, and it is quite large enough, thank you. So why pile those other three risks on top of it?”
By using actively managed funds, you’re buying into a negative correlation between risk and reward. You’re taking a greater risk — and, statistically, you can expect a lower reward, especially once the considerable extra cost of investing in active funds is factored in.
If you’re using active funds, ask yourself, Why? If you were recommended active funds by a financial adviser, ask the same question of them. You may well have been badly advised.
This article was originally written for the Fair Return blog. Fair Return is a claims management company that specialises in helping UK investors to claim compensation for excessive fees and charges they may have paid.
You’ll find more details on the website, and you can follow Fair Return on Twitter at @aFairReturn.
Picture: Brett Jordan via Unsplash