Monday, January 18, 2021

Understanding Investment Expected Outcomes

Winkler's Law of Investor Risk/Return Trade-Offs: Any time an investor begins a statement affirming they understand the basic risk/return trade-off (high return comes with high risk, low risk implies low return), they are invariably about to implicitly or explicitly argue against it. 

There are specific meanings of risk and return as used here. This is financial risk and return. Risk can be understood as variance or volatility of price. Return is the outcome realized (selling price plus income derived during the time held minus the price paid and costs borne). Once you realize that "high/low" return doesn't mean "good/bad" return but rather means "big/small" return, you'll be a lot closer to understanding what finance people understand about risk/return. Risk and Return are simply two names for the same thing in this framework.

If you buy a share of stock at $100, hold it for a year collecting $2 in dividends, and then sell it, the outcome is going to be high or low. If you sell it for $101 or $95, the outcome was low in either case. In this hypothetical the return and risk were both low. Selling for $10 means a $3 profit ($2 dividend plus $1 price improvement). Selling for $95 means a $3 loss ($2 dividend minus $5 price deterioration). Regardless, the outcome of an approximate 3% return (positive or negative) is a low return.*
When the meaning of "risk" is relaxed to include risk of individual ruin (financial or otherwise), hypothetical scenarios that do occasionally exist move from Low Risk/High Return to High Risk/High Return (extreme example: let's bet on 10 coin tosses in a row where for each one if you choose correctly, I give you $1,000,000 and if you choose incorrectly, you pay me $500,000) or from High Risk/High Return to High Risk/Low Return (fairly common example: concentrating nearly all of one's financial wealth in a single stock). 

Bad decision making can move hypothetical scenarios from High Risk/High Return to High Risk/Low Return (example: excessive amounts of slot-machine play--the repetition gives the house a greater and greater advantage . . . start with a 90% payout return, then keep playing . . . 90% times 90% times 90% means the house goes from a 10% edge keeping a dime for every dollar you wager to a 27.1% advantage keeping 27 cents for each dollar through the rewagering). 

The grid is generalized and one should think of these realms as in the extreme. There are certainly examples that would technically fall into the unrealistic realms (hence the name unrealistic rather than impossible). These opportunities (Low Risk/High Return) and pitfalls (High Risk/Low Return) are fleeting, rare, difficult to truly experience, and usually of small magnitude. To good to be true is basically a mathematical and economic fact. 

*Yes, "low" is a relative term--relative to the state of the world. Just assume with me that most returns that are 3% are "low" or change the numbers to make it so in your mind. The amount isn't critical to the point.

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