Do You Know What You Want?

The world of finance and investment has fixed rules and laws. Knowledge of these will bring you a number of benefits. You will be better able to set your investment goals, choose more responsibly from a large array of investment opportunities and, last but not least, harmonise your expectations with actual opportunities. You may even find that these are far greater, or substantially fewer, than you had imagined. At the very least, you will be a better judge of what the future will bring.

1. Higher return = greater risk.

VIn the professional practise of financial advisors it isn't unusual for an investor to define his requirements as follows: "I'll be happy with 10% interest annually, but please invest my money safely." Such a request reveals a total lack of understanding of the basis of financial investing. Not only is the word "interest" simply wrong here (the term is only used in connection with cash, e.g. for bank deposits; investments in other financial instruments yield other types of revenue), but the client fails to realise the necessity of risk.

The golden rule says that the higher the required return, the greater the risk. For every currency there exists a certain minimum yield that may, in principle, be achieved risk-free. Its amount is represented by the discount interest rate set by the central bank responsible for a given currency (for the crown it is the Czech National Bank; for the US dollar it is the central bank of the USA - the Fed). Commercial banks base their fixed term deposit interest rates on this rate. If the investor requires a higher than risk-free return, he must accept that his invested money - and the expected return on it - will be subject to some degree of uncertainty.

E ... Expected Return in %
SD ... Risk (Standard Deviation)
Rf ... risk-free interest rate

The higher the return (E) that the investor requires, the higher the risk (SD) that he must accept. When investing at a risk-free rate (e.g. by buying treasury bills issued by a central bank) you can be sure that you won't lose your investment (excepting the hypothetical possibility of state bankruptcy) and you are guaranteed to receive regular payments. When investing in riskier instruments (e.g. stocks) not only could the value of your investment decrease in the future (the price of purchased stocks goes down), but moreover the stocks need not yield any return in the form of dividends. So why invest in such instruments at all? The answer is simple - statistics show that investing in a high-quality stock portfolio and its long-term holding yields more on average than investing in safer, less risky instruments. The phrase "long-term holding" is key here - the investor can offset necessary risk by setting a longer investment period during which he is able to leave his investment untouched - the investment horizon. Given a sufficiently long investment horizon (e.g. 5 years) overall risk significantly decreases and there is greater probability - though never a certainty - that the investor will achieve the expected return.

In other words, the risk corresponds to how much (particularly in the short-term) the investment deviates from expectations. Riskier investments are volatile, i.e. their value is subject to greater "fluctuation", while less risky investments behave (earn) in a more stable manner. The higher potential return thus constitutes a premium for accepting risk. That's why it's never possible to guarantee a return higher than the risk-free interest rate. The following graph documents this situation by comparing two investments over the course of 750 trading days (i.e. about 3 years, trading days = business days when financial markets are open). While the first of these (indicated in blue) slightly but steadily rises for the entire period, the value of the second investment with the higher expected return fluctuates considerably and, in fact, incurred losses during its first year. But at the end of the investment period, it came out far ahead of investment A: 

The existence of risk means an element of uncertainty as to whether investor expectations will be met. Such a deviation from expectation can take the form of a decline in investment value or lower than expected yield, but for the sake of thoroughness we should add that the deviation may work in the investor's favour, i.e. the realised return can exceed expectations. All these scenarios may be quantified, and their probability determined in advance, using statistical methods. If investment B of our example is placed upon a three-year investment horizon, such an overview of the probability of possible returns could appear as follows (the value of returns p.a. - on an annual basis):

The average return on investment B (roughly 8% p.a.) thus statistically places it among the most probable values. However, the possibilities of a higher return or a loss were not discounted. In our case, the investor who went for variant B was lucky, but a three-year investment horizon is still too short for such a volatile investment if we want to render the risk of loss negligible.

2. Investment effectiveness - the Sharpe ratio.

Ideally, what should the client requirement described in point 1 look like? The right request should sound something like this: "I'll be happy with a 10% annual return above the risk-free rate. Please tell me the lowest risk value I'll have to accept." We have already said that in exchange for the possibility of a higher than minimum (risk-free) return one has to accept a certain degree of risk with one's money. But how high a risk? It is quite obvious that an investment with the maximum potential for an average return involving minimum risk would be optimal.

Professor Sharpe, the great financial theorist and Nobel laureate, looked at this problem. If we have two available investments, each with an already known average return (E - the statistical mean value) and risk (SD - the statistical standard deviation), the investment with the higher yield/risk ratio is more effective. This mathematical expression is called the Sharpe ratio and the knowledgeable investor won't go wrong by taking it into account when making an investment decision. While the Sharpe ratio attains a value of around 0.5 for standard stock portfolios, the sophisticated investments of various hedge funds often record a ratio greater than 1.

And an interesting bit of information to conclude. It is clear that the higher your investment's Sharpe ratio, the better. But exactly "how much" better is a higher ratio? Without knowing the statistics, it's virtually impossible to answer this question correctly, but it is true that Sharpe ratios must be compared to the second power. In other words, a Sharpe ratio of 1.0 is four times better than (and not only twice as good as) a Sharpe ratio of 0.5. This fact is tied to the mathematical method of defining risk as a standard deviation describing how the possible value of a future return on average differs from the expected (mean) value. In order to reduce the standard deviation by 1/2, we have to quadruple the time (as described above, total risk decreases over time) or the investment must record four-times less "fluctuation".

3. Conservative, dynamic, or aggressive investment - how to choose?

The above mentioned relationship between risk and return was the impetus behind the investment variants proposed by RSJ. For an investor who prefers safety or has a shorter investment horizon, the optimal choice is conservative management. In the basic variant, investment volume never drops below the initial deposit; indeed, it steadily gains in value. Although the return reflects the risk-free interest rate, it remains higher than an ordinary term deposit due to our effective placement of client funds on financial markets without unnecessary fees. For investors with a longer investment horizon, we create a portfolio that surpasses the risk-free interest rate with a minimum degree of risk.

On the other hand, a long investment horizon, the ability to accept fluctuations in the investment's value and the willingness to bear a potential loss in exchange for a high potential return are the hallmarks of an aggressive investor. Our hedge systems optimise expected return in relation to risk and attain excellent Sharpe ratios in comparison with stock portfolios.

Dynamic solutions are designed for clients with a medium to long-term investment horizon who are not inclined to favour any of the above mentioned variants, but are looking for a reasonable compromise. The majority of dynamic portfolios combine multiple strategies and investment in both conservative and aggressive schemes.

4. Investment psychology.

Let's look at a situation where an investor has decided to deposit CZK 10,000,000 into our example risk investment B above. The investment did not start out so well. It was several weeks before the position was completely purchased. There was clearly a market reverse and in this period the investor suffered a 5% loss. Of course this didn't add to the investor's sense of calm, but he was well aware of the expected risk.

The situation failed to improve in the months to follow and the investment continued to be loss-incurring. This was very unpleasant, and spurred the investor to become highly critical of his investment decision. However, after a year the situation turned around, the investor was in a profit position and after another month his total return of 10% exceeded safe investment A. The investor was thrilled. As we will see, however, this was premature. After several more months the profit disappeared and the investor was right back where he started. Nevertheless, he very wisely persevered. Even though as the third year began the return on investment B was lower than the return on safer investment A, at the end of that year it had handily pulled well ahead.

After studying the graph tracing the development of both investments, it might seem relatively clear which variant to favour. In real life, however, the circumstances are otherwise. No one can see into the future and all an investor ever really has at a given moment is knowledge of current developments and a table of probabilities. Indeed, if an investment fails to perform, it is the rare investor who can avoid pessimism and doubt.

The ability to deal with risk means knowing how to take a loss and not succumb to panic should an adverse situation develop. If you overrate your relationship to risk, your investment can turn into a nightmare for several months or years. A feeling of satisfaction with one's investment is not proportional to the expected return, but depends on momentary comparisons. An investor who has a tendency to regret his decisions when times are bad or to become overly pessimistic should never subject his money to a higher degree of risk.

Surprisingly, too much activity and self-confidence can also be a detriment. Investors with these features have a tendency to change their investments too often and believe they recognize when an investment instrument is sufficiently "cheap" (and thus ripe for buying) or "expensive" (and should be sold). Such behaviour not only increases trading costs (every purchase and sale costs something), but practice has shown that it mostly turns into a fiasco. On the contrary, it pays to hold an investment for the long-term. For example, the development of American stock prices in the years 1925 - 1995 shows that 99% of all returns were earned within a mere 4% of the time. Because we can't predict when this key 4% of the time will be, it pays to hold on to a portfolio. Otherwise, your activity cannot be called investing, where one relies on a long-term yield trend, but rather speculation which is more like a game of chance. And as we all know, few win while most lose in games of chance.

Summary.

If you require a higher return on your investment, you have to consider the fact that your money will be subject to a higher degree of risk. That's why you should always answer two questions before committing to an investment:

In other words, you need to consider your investment horizon and estimate the degree of risk that is tolerable for you. You can formulate your plan, for example, based on a requirement that at no future time you lose more than 20% of your invested monies. Another formulation might be that on maturity of your investment you accept, in the worst case, to get back the original investment value. Based on such a request, an investment advisor can create several investment variants. You can then compare these using the Sharpe ratio or any other suitable methods.