The stock market of late has done nothing but go up of late. The Dow keeps pushing through market milestones. Not only that its progress is coming with a decided lack of volatility. All of which can leave investors a bit full of themselves.
Which is the perfect time to revisit the relationship between risk and return. I noticed this past week a series of posts all of which talked about risk and risk management. It may not seem like it now, but risk and return are still connected. At some point in the future the stock market will take a nasty, unexpected fall. So now is the time to be thinking about risk.
In his new book, Don’t Fall For It: A Short History of Financial Scams, Ben Carlson takes a look at some notable historical financial scams. One of the common themes among them is that they all were built on claims of having upended the relationship between risk and return. I think Ben states it really well here:
“Every successful investor must understand there is a sacred relationship between risk and reward. There is no proven way to earn a high return on your capital without taking some form of risk from your investments. At best you can trade one risk for another because it never really goes away.”
One of the most frustrating things in investing is that we never really know the true odds. Unlike in gambling, where the odds are explicit, in investing we are estimating, inferring and modeling the risks involved, but they are all just guesses. Howard Marks at Oaktree Capital has written a lot about risk, including in his book. In his most recent monthly letter he wrote:
“Success in gambling doesn’t go to those who pick winners, but to those with the ability to identify superior propositions. The goal is to find situations where the odds are generous to one side or the other, whether favorite or underdog. In other words, mispricing. It’s exactly the same in investing.”
Morgan Housel at Collaborative Fund not surprisingly had a great take on risk. He writes:
“We are bad at forecasting the economy. But that’s not because we can’t analyze how an event will impact the economy. We just can’t analyze events we haven’t considered to begin with. Risk is what you don’t see.”
So if the world is decidedly uncertain, what can we do? Morgan notes that we should model our systems based on the worst case scenarios and build as much slack into our responses as possible.
It should be clear by this point investing (and life) is full of risk. Doing anything of note requires taking on some risk. Forewarned is forearmed. As Jeremy Walters at Calibrating Capital writes:
“There are some types of risk that you can insure against. There are other types that you can diversify against. And there are other types you simply can’t do anything about.
virtuallyimpossible to eliminate all risk. And that’s ok. As long as we’re aware of it, and we recognize the importance of flexibility”.
Nobody knows with certainty what is going to happen in the stock market, Presidential election or the coming Super Bowl. All we can do is position ourselves so that the worst-case scenario is one we can survive, so that we can keep moving foward.