David Kirk on why high risk doesn't always mean high return

NZ Herald

2 days ago

The common claim we all hear in investing is 'the greater the risk, the greater the return', but is this true? Photo / Getty Images
The common claim we all hear in investing is 'the greater the risk, the greater the return', but is this true? Photo / Getty Images
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Former All Black captain David Kirk, now chair of Rugby New Zealand, joins Listener.co.nz as a columnist taking a philosophical look at money, finances and living well. The co-founder and chairman of Bailador Technology Investments, Kirk sits on a number of other boards including investee companies of Bailador and charitable organisations.
Predicting the future is an age-old pastime. Causation, correlation, extrapolation and fantastication are a few ways to do it.
Science predicts the future by predicating causes. The scientific method hypothesises causes and then seeks to disprove them. If causes can't be disproved, they stand as conditional scientific truth.
Einstein published his Special Theory of Relativity in 1905. To my knowledge the theory has never been definitively proved, but all the experimental evidence entirely supports the theory. E=mc2 is just one component of the theory but the validity of the equation has been demonstrated by, among other things, nuclear reactions and nuclear decay, where the loss of mass in a nuclear explosion or in slow radioactive decay exactly matches the energy released divided by the speed of light squared.
A series of events are correlated if they happen with the same relative frequency over time. Every day it gets light when the sun comes up. The two events are correlated. And in this case, they are causally related. Every morning the rising sun causes the steady creep of daylight. But causation and correlation are not the same thing.
I put 'spurious correlations' into an internet search and found out that over 40 years the number of hotdogs consumed in an annual hot dog eating competition in the US has been very closely correlated with the number of annual automotive recalls, and that annual air pollution levels in Iowa City over 18 years are closely correlated with the number of library technicians in the state, and that for more than 30 years the popularity of the first name Waylon in the US is very closely correlated with wind power generation in China. Who would have thought? Beware of correlation masquerading as causation.
Extrapolation is the most common way of predicting the future. We know what happened yesterday, which is the same as today and we think it is most likely to be the same tomorrow. And we are right. Tomorrow is most likely to be like today. Until it isn't.
The major catastrophes that virtually no one predicts are called 'black swan' events. Nassim Nicholas Taleb has written a good book called, surprise, surprise, The Black Swan on these types of events. We shouldn't worry about black swan events. We don't know when they are coming, we don't know what form they will take, and we don't know what impact they will have, but we can take sensible precautions, like not putting all our money into bitcoin and not building our house on a flood plain.
Or we can just make it up. We can imagine the future and it can be what we want it to be. It can be our fantasy. Quite a lot of people make money from imagining what the future will be like. Novelists, weather forecasters, tarot card readers and economists are a few examples.
No one can predict short-term financial returns. But long-term relative financial returns can be fairly easily predicted by extrapolation.
The common claim we all hear in investing is 'the greater the risk, the greater the return'. This is absolutely not true when assessing individual investment decisions, but it is possible to group investments, such as, say, bank deposits, a share market index, property, and a marijuana plantation in Northland and, for each investment, to derive both a long-term expected return, usually by extrapolation of past returns, and determine the risk of achieving that return. The risk is assessed by extrapolation of the volatility of past returns.
Let's say we were to rank the list above from least risky and lowest return to highest risk and highest potential return. We might come up with: bank deposit, property, share market index and investment in a wacky-baccy oasis up north.
Regular readers will remember last week we discussed opportunity cost and compared the opportunity cost of having an investment in the bank to the same investment in the share market. The bank paid a 4% interest rate, and the share market produced a 7% return, delivering a -3% opportunity cost of capital for the bank deposit.
But our ability to predict the future purchasing power of the bank deposit is greater than our ability to do the same for the share market investment. So, discounting future cash flows to today at a lower rate for the bank deposit than for the share market investment reduces the negative opportunity cost of capital of the bank deposit compared to the share market investment. The financial world description for this is 'risk-adjusted return'.
Stephen Hawking famously included just one equation in his bestseller A Brief History of Time on the advice of his publisher, who he recalls telling him sales of the book would decline in proportion to the number of equations he included. It's good advice well taken and I will not set out the equations quantifying the difference between simple returns and risk-adjusted returns. The logic is clear. The riskier the future potential return, the higher the discount rate required to determine the value of the investment today.