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Risk and Return

By James H. Nolt

It's commonly understood that there is a trade-off between risk and return in both personal and corporate finance. In other words, if you want higher return on your investments—whether in the form of interest, dividends, capital gain, or profit—you need to take on additional risk. On the other hand, if you are risk averse and want to play it safe, you must settle for lower return on your invested capital. This is nearly always true with outsiders, like most of us, who lack the power to move asset prices or influence credit availability.

Yet as regular readers of this blog may have guessed, return on capital depends a lot on power, too. Powerful insiders can often reap considerable profit with little risk.

Economists and financial advisors tend to classify financial products along the two dimensions or two axes on a graph—risk and return—to emphasize the trade-off. One stock, let’s say a rapidly growing tech company, is classified as risky because the company’s prospects are uncertain, but it has been growing so fast its stock is shooting up, even if the company has not yet earned a profit. The stock yields high returns (so far) in the form of capital gains. Another stock might be low yield but safe: Imagine a stalwart blue-chip company that exhibits lackluster capital gains, but pays a modest and reliable dividend. Even safer is a supposed “riskless” asset like U.S. Treasury bills, but the yield on those is very low, currently around 0.5 percent nominal yield, which is negative counting for inflation.

The first point to keep in mind is that risk is embodied in financial strategies, not in financial assets. The risk associated with an asset derives from the strategy of the issuer of the asset. For example, the high-flying tech company is magnifying its growth rate because it is piling up debt as fast as it can borrow. As long as it can earn a rate of profit that exceeds its cost of debt, such a bullish strategy will pay off. If not, it becomes a falling star, ending up as a “dog” stock, if not bankrupt. In a booming economy, the stodgy low-debt blue chip company may lag behind better-funded competitors, falling from low risk to even lower value. Like the game “rock, paper, scissors,” no strategy is always safe or always high yield. The business cycle, when it turns, reshuffles winners and losers.

Even supposedly “riskless” assets such as cash or Treasury bills are not riskless at all. Price inflation can erode their value rapidly. Having low or no return on your assets is no guarantee of safety. It all depends on the macro environment. I once taught from a famous economics textbook that said that if your ancestor 200 years ago had invested $10 in a bank at a fixed compounded interest of 5 percent, this would be worth over $31,000 today. While this is mathematically correct, this assumes a riskless world that has never existed. A nominal rate of return of 5 percent is a loss of real capital whenever the rate of inflation is higher than that. Furthermore, losses and gains are not symmetrical. If you lose 5 percent for five years, then gain 5 percent for the next five years, you are not back where you started, but in fact considerably poorer. Even worse, very few banks have survived for 200 years. The chances are high that within such a long period you would have lost your entire capital in a financial crash that sank your bank. Cash is no safer. It has no yield on its face value, but rises or falls in value according to price deflation or inflation.

The second point to remember is that any strategy is safer if you have power. This is obvious in military strategy, but typically forgotten in economics and finance classes. For example, during recent decades, government bonds have tended to be lower yield than corporate bonds. Textbooks will tell you this is because governments are less likely than corporations to default on debt. That was not always the case. Until the past century, the best corporate or mercantile debt almost always yielded less than most government debt because governments had a nasty tendency to lose wars or suffer revolutions. When they did, their creditors ate the losses.

Finance theory, like economics, assumes no market participant has any power to influence prices. This is a reasonable assumption for outsiders, but nonsense for all insiders, including the issuers of securities themselves. Insurers of debt (bonds and bills) and equity (stocks) all have the power to influence the value of their own securities, for better or worse. For example, if a company wants to raise its stock price, it can buy a lot of its own stock back from the public. U.S. companies have been doing that a lot in recent years. This is one thing that has been propping up certain stock prices. On the other hand, diluting a stock by issuing more shares typically lowers its price. In both cases these effects can be counteracted if there is even more market pressure in the opposite direction.

Therefore, to understand risk, you must understand the strategies of insiders. It is the same as in war. Unfortunately, as in war, insiders seldom have any reason to share their strategies with outsiders. Unless you run spies, the best you can do is what good generals do: hone your intuition for what insiders with real strategic power are likely to do in various circumstances. You need to anticipate the thinking of others. Without these skills, strategic investing is not for you.

Even very powerful players can be blindsided by others with power, just as history’s mightiest warlords may nevertheless meet their Waterloo. Financial players often try to minimize their risk on big operations by forming cartels, more often called syndicates or consortia, to share profits and avoid competition. If most potential adversaries are fellow insiders, that is one reliable way to manage risk. If you can’t fight them, join them.

The very phrase “risk management” is interesting. In the textbooks, it is taught according to rules like diversification and measuring risk on the basis of past price behavior. Past volatility is taken as a metric of future risk. These techniques are hopelessly misleading if you consider the world from an insider’s viewpoint. Managing risk from an insider’s perspective is much more like military strategy. The most useful tools are deception and surprise. Of course, sheer force (the amount of capital you can put in play, whether your own or under your management) goes a long way to winning financial battles, as with military ones. Deception and surprise can be massive force multipliers. This is why you will never go far as a financial strategist if you rely only on publicly available data or news. Anything easily known is probably strategically useless. Real insider risk management is about manipulating the political and business environment in your favor, using deception, surprise, and organization to leverage capital.

During the coming weeks I will delve deeper into bear and bull strategies to illustrate these points.

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James H. Nolt is a senior fellow at the World Policy Institute and an adjunct associate professor at New York University. 

[Photo courtesy of bifishadow]

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