The Many Facets of Risk, Reward and Uncertainty

In discussing annuities in yesterday’s post, I referred to its risk/reward matrix. Huh? What’s that?

When you invest your assets in something, you expect to be rewarded with some amount of return. And you take on risks of different sorts: the uncertainty of returns; fluctuations in value; default; etc. But rather than thinking about what specifically can go wrong with a given investment, think instead of the many facets of risk and uncertainty generally. You can picture all those different facets as creating a risk/reward matrix for any investment, where the magnitude of each facet differs for each type of investment. Focusing on these facets can help you determine how much of each type of risk you can afford.

Here’s a summary of some of the many facets of risk and uncertainty. I’m sure it’s not complete, and I invite you to post a comment or send me an email to round out the list.

A. Volatility of Returns. Sometimes an investment gives good return; sometimes negative returns. How much can you expect the return to fluctuate over the long run? (By long run, I mean your particular time horizon, between now and when you’ll need to spend the money.)
a. What’s the highest annualized return you might reasonably expect over the long run?
b. What’s the worst loss (negative return) you might expect?
c. What’s the spread; the difference between the two?
d. What’s the likely spread; eliminating the outliers, say, the 10% best and 5% worst returns?
e. What’s the standard deviation? On second thought, forget standard deviation! That’s a statistical measure that is meaningful when, say, playing craps in Las Vegas, but it serves no useful place in the turbulent, non-Gaussian world of investments. Relying on standard deviation and other inapposite arithmetic is what got our banks into the economic mess we’re currently paying them to rectify.

B. Win/Loss Percentage. What percentage of the time will an investment succeed in the long run, and what percentage will it fail?
a. To retain its nominal value?
b. To retain its real, i.e., inflation-adjusted, value?
c. To outperform a relatively risk-free investment alternative?
d. To achieve a realistic goal that’s important to you?

C. Return/Likelihood Matrix. What is the likelihood of this investment achieving each and every different percentage of return (or loss) over the long run? Nobody really knows this, but we all act as if we do. We can’t help ourselves. We feel we must assign probabilities based on past performance, even though past performance is an imperfect guide to the future.

D. Expected Return. Over the long run, what is the “average” expected return? It’s funny, but we want to know the average, even though that’s a number that’s not likely to repeat itself in the particular future we embark on today.
a. What’s the past median return?
b. What’s the past geometric average?
c. What’s the past arithmetic average?
d. What do the experts prognosticate for the particular future we are about to embark on?

E. Competing Investments. In the long run, how well has an investment performed against competing investments? After all, all your investments will be performing in a single specific economic environment, which may be good or bad.
a. How often was it the best performer?
b. And how much better was it?
c. How often was it the worst?
d. And just how much worse was it?
e. How much better or worse did an investment perform as you dial up or down your percentage allocation to that investment?

F. Interim Volatility. How scary will the ride be as your particular future plays itself out? For example, stocks might snap back to their historical average returns, but it sure has been sickening to watch them fall by 50% while we wait for that to happen. Sickening enough, perhaps, to cause you to sell at their low point. So even ephemeral losses matter if you react to them.
a. What percentage of the periods (years, months, days) has an investment lost value?
b. What range of interim losses has an investment experienced?
c. What range of ephemeral gains has it experienced?

So it turns out we use the word “risk” to encompass many different things. Nothing’s easy.