Risk/Reward Ratio
by Doyle Ranstrom on Jul 24, 2019
In investing, we often talk about risk/reward. The reward is the potential success of an investment strategy and risk is the potential for the strategy to result in a loss. Though often we do not often think about it, risk/reward is part of all of our decisions. I tend to think about this all the time because I like to think I am thoughtful, others, less thoughtful have suggested I am obsessive and a worrier.
An easy example is being in a vehicle, either as a driver or passenger. The reality is every time, someone gets into a vehicle there is a risk/reward ratio. The reward is getting to where the person wants to go. The risk is an accident. They're about 6 million vehicle accidents annually in the US, with over 3 million people injured and it was estimated about 40,000 deaths in 2018. Accidents can mean substantial financial costs, including loss of time, vehicle costs not covered by insurance, and costs related to injury and death. Most of us never think about being in an accident when we get into a vehicle, but that does mean the risk does not exist. However, there is a good reason we do not think of this, otherwise, we may be paralyzed by fear.
- There are ways to reduce risk. Wearing a seatbelt. Not drinking and driving. Driving a newer vehicle that has current technology. Not driving when tired.
- Another is avoiding driving in bad weather. Living in Fargo, most of my adult life, driving bad winter weather was a given. Early in my career when the children were small, I made a conscious decision to not drive out of town in bad weather. As the primary source of income for the family, the risk of driving in bad weather outweighed the potential reward. I rescheduled meetings, and more than one client told me I was a "weenie" but it was a good risk/reward decision. I only broke this inner rule once. A few years ago, while still living in Fargo, in February I had a medical appointment Rochester Mayo. There was a strong blizzard moving in, but my wife and I went anyway. Driving knowingly into a blizzard is at best, to use a technical term, dumb. We made it but it was almost 100 miles of total white-out with a stream of vehicles stuck, some upside down. Because we made it, it does not mean it was a good decision, we were fortunate.
What does this all have to do with investing? All investments have a risk/reward ratio. The reward is the potential return on the investment. The risk is the potential for losing money.
Before going farther, investors who believe that investing solely money market or short-term CD's have no risk, I would suggest are incorrect.
- One risk is the decreasing power do to inflation. For example, at a 3% inflation rate over ten years, it will take about $134,000 to purchase the same goods as $100,000 did at the beginning of the ten year time period. An investor whose average return is less than the inflation rate is losing money.
- Another risk is the reduction of financial resources before and after retirement.
- A pre-retiree who at age 45 has $100,000 and adds $10,000 to it annually, has a 7% average annual return the next 20 years has a retirement account of almost $800,000. By comparison, a pre-retiree who averages 2% has about $392,00 or about 50% less money to live on throughout retirement.
- After retirement, a retiree who at the beginning of retirement has a portfolio of $500,000 from which the retiree withdraws $25,000 annually for income and averages 6% for the first 20 years of retirement has almost $669,000 in the portfolio at the end of the 20 year time period. By comparison, a retiree who, withdraws $25,000 annually averages 2%, only has about $135,000 left in the retirement account at the end of the 20 year time period.
To me being solely invested in low-risk accounts over a long period of time is actually a high-risk investment strategy.
It is easy to define risk when getting into a vehicle. Defining the risk in an investment account can be more difficult. For me, the risk of investment account is losing all the money. In other words, having the market value of the investment goes to zero.
However, for many investors, losing money is a decline in market value on a performance report. Though I would disagree with this definition, for investors who do believe this, they should define this risk specifically. In other words, what is an acceptable decline before the investor will make an emotional, and too often bad investment decision? Specifically, at what point will an investor turn a paper decline into a realized loss.
Though most of us do not think about risk/reward every time we get into a car, it's there. When investing, I believe it is important to initially consider and regularly review risk/reward. This includes a discussion of investment objectives, a time horizon, the desired rate of return along with expected return [expected return is different and I believe more beneficial than historical return] and potential downside volatility at any time during the time horizon.
There are very good reasons for an investor to change investment strategy, both when a portfolio is increasing and decreasing. However, if the investment declines and the investor makes an emotional decision turning a paper loss into a real one, I would suggest this is a failure on the investor’s part to understand the risk/reward ratio for the investment strategy. It seems to me, this is the equivalent of a driver seeing an accident, getting out of his/her car, and stopping the trip immediately. Neither makes sense.