Almost everyone knows that they need to invest their money to help prepare for retirement. It’s one of the keys to getting where you want to go. The markets may (ok, they will) bounce around in the short-term, but over the long-term they have done very well for disciplined investors. But why have markets been good to investors over the long term? Why should you get those returns for simply investing your money? What’s the actual reasoning here?
Well, the reason is that the market is paying you to take on risk. At root, there is a certain level of risk inherent to the financial markets that needs to be borne by someone. We can slice it up, and pass it around, and play all sorts of financial engineering games to do things as efficiently as possible, but there’s still that risk inherent to the financial markets that needs to be dealt with, no matter how clever we are.
And every stock and bond out there is its own little ball of risk. If you go out and buy a share of Amazon, you’re buying all sorts of risks – and only some of them are part of those inherent, or systematic, risks that actually need to be held. Along with those systematic risks, you’re also getting a whole bunch of risks that are specific to Amazon, or a sliver of the market, that essentially go away when you combine them with all of the other balls of risk out there. These risks that aren’t systematic risks to the markets are called unsystematic risks (us financial folks aren’t all that great at coming up with creative names for things).
A good way to think about this is to think about a mining company. Say you own the stock of some gold mining company. Well, as you might imagine, when the price of gold goes up, that stock is probably going to do well. When the price of gold goes down, that stock probably isn’t going to do very well. It’s straight-forward. What isn’t straight-forward is the fact that this risk isn’t actually one of the systematic risks that the market needs someone to hold (and therefore will pay you to hold).
Why this isn’t a systematic risk becomes obvious when you look at the market as a whole. There is a relatively small group of companies that mine gold, but there is a huge number of companies that use gold, and since they’re buying gold, rather than selling it, their reactions are exactly the opposite from the gold mining companies. When the price of gold goes up, their costs go up, and they’re less profitable and, in general, their stocks will go down. But the effect is a lot less pronounced than it is for the gold mining companies. The price of gold is pretty much everything to a gold mining company, but it’s a relatively small input for an electronics manufacturer.
But remember, those gold mining companies have to be selling the gold to someone. They aren’t mining gold for the fun of it. This means that, to the extent that this activity is happening through publicly traded companies, the effects cancel across the market. If you own a market portfolio, the price of gold doesn’t have a huge impact one way or the other. The gold mining stocks that you own will do really well when the price of gold is high, but everything else will do just a little bit worse.
This is the fundamental way of identifying what is, or is not, a systematic risk – if you own the market, will you care about a particular risk? The really important question is will this risk cancel out, or is it something that actually needs to be held by someone in the markets? In the end, the market will only pay you for holding the systematic risks – they’re the only ones with positive expected returns.
Risk and return are related. They aren’t quite two sides of the same coin, but the markets aren’t there to just give you free money. You need to provide a service to the market by taking on some systematic risk before you can harvest the long-term returns. You can take on all sorts of risks without increasing your portfolio’s expected long-term returns, but you can’t get higher expected returns without taking on more risk.
This doesn’t mean that they’ll go up every year. That much is obvious from just a quick glance at the financial markets. Investing is about risk, and, well, all risk is risky. If there wasn’t a chance that things wouldn’t work out, it wouldn’t be risk, and there would be no real need to pay people to hold it.
As people, we don’t really like risky things. We are all, to one degree or another, risk averse. It feels worse to lose $10 than it feels good to win $10. We need an incentive to do something risky. It doesn’t matter if that incentive is financial, or that something would just look really cool.
To see this yourself, let’s say that I was going to flip a coin. If it comes up heads, I’ll give you $100, but if it’s tails, you’ll owe me $100. Almost no one would take that bet. There’s simply no reason to do so. The expected return is $0 – you are equally likely to win or lose that $100. However, if I start adjusting the payouts, either increasing the amount you win, or reducing the amount that you lose, eventually we’ll reach a point where you will be comfortable taking that bet. You’ll find the point where the expected return of the bet outweighs the risk of the bet.
Well, this is exactly what the markets are doing. They are continuously finding the point where someone is willing to take the bet for each and every security, but there is something that’s a little unsettling in what this implies. The implication is that every time you buy a security, you are the person who is most willing to take that bet; you’re the person who requires the lowest expected return to buy that particular security. Otherwise, the security would have been bought at a higher price. Someone would have bid more for the security, which means a lower expected return (all else equal). What this means is that you always need to be thinking about how you are different than the average investor. Thinking about how you’re different from the average investor can help you see the risks that you are more able to handle than most people, and what risks, and in what amount, make sense for you to take on.
The market doesn’t give away returns for free. To get the returns that most people are counting on to reach their retirement goals, you need to take on some of this systematic risk that the markets need to deal with. You simply can’t get higher returns without taking on more risk. But you can definitely take on more risk, without getting higher returns.
To find out more about how to make sure you’re taking the right type of risk, and how to work with it, read 12 Principles of Intelligent Investors.