Risk is inextricably tied to return. It is not true that taking higher risk means you will see higher returns, What is true is that higher risk raises the probability that you will harvest higher returns. It also raises the probability of losses (see our last post).
Part of any investment manager’s job is to gauge the potential risk of an asset. If you accept a ‘lock up’ on an investment preventing you from selling it for a time, risk increases. If debt is used to finance the asset, risk increases. If operating results are lousy, risk is high. If an investment has multiple partners, risk can be high depending on entity structure. Merging companies present risk, even building a new plant can be risky. Once you identify sources of risk, the next rule is to get paid for accepting that risk.
You can’t know what future returns will be, but many assets offer clues. A stock that pays a 6% dividend yield when everything else is yielding 3% is probably riskier than normal, but that upfront payment is a good start towards a healthy return – if the payout can persist. Real estate investments that offer net cash flow of 3% or 4% in addition to future rent increases and modest appreciation; bonds that sell at a discount and also pay cash flow of 5% to 6%; private equity investments with ever growing valuations at each new investment round; these are examples of assets that could deliver above average returns.
What’s ‘average’? We benchmark most assets to long term stock returns, which are roughly 9.5% per year since 1926; bad years can shave 45% off your portfolio value. If you are taking stock-like risk in some exotic asset, with potential losses on the table, there had better be a potential return above 9.5%. Bond returns since 1926 – using intermediate corporate issues as our benchmark – are between 5% and 6% per year on average; bad years are not really very bad in the bond department, with losses only amounting to about 5% in the worst year for these maturities. If you finance a real estate development for your buddy, you are essentially issuing a private bond, and you’d better insist on more than 6%.
Using comparisons to historical returns and losses lets you approach risk with eyes wide open.