Originally published by Cuffelinks
We know that humans have been infatuated with gambling throughout history. Some of the earliest games of chance were forms of a dice game that used the squarish knucklebone of hoofed animals. Gambling was a constant fixture in the lives of both the ancient Greeks and the Romans. Pontius Pilate’s soldiers cast lots for the robe of Christ as he suffered on the cross. In Greek mythology, three brothers rolled dice to decide how to divide the universe. Zeus won the heavens, Poseidon the seas, while Hades, the loser, was sent to hell as master of the underworld.
Our obsession with besting chance has not changed since ancient times. The total known sum of global gambling losses was estimated at US$400 billion in 2017, equivalent to roughly one third of Australia’s annual GDP. Undoubtedly, the actual amount is far higher since Americans are estimated to wager US$150 billion a year on illegal sports betting alone. In Australia, gambling is almost the national pastime. Australians are the biggest gamblers in the world, losing on average $990 per resident adult in 2016, 40% more than runner-up Singapore.
Separating investing from chance
Gambling is part of the human experience, but what separates a random game of chance from the supposedly more highbrow venture of investing? Indeed, the inexorable rise of the passive investment industry is based on the uncomfortable truth that few professional investors outperform the market over long periods.
In the age of Exchange Traded Funds (ETFs) and efficient financial markets, generating investment returns is in fact relatively easy. Over long enough periods, most asset classes generate positive investment returns. Given this, the skill of investing can hardly be thought of as the act of generating positive returns. This is especially the case during periods like the present 9-year equity bull market. Instead, what should separate investing from a random toss of a coin is the skilful assessment, management and bearing of financial risk. The real art of investing should be in generating better returns than what the pre-investment odds would have forecast.
Yet, investment risk remains one of the least talked about aspects of investing. Most investors know what their portfolio returned last year but ask that same investor how much risk they bore to generate those returns and too often, the response is a blank stare.
Given the fundamental principle of investing is ‘risk versus reward’, it is unnerving how little time is spent contemplating risk.
How do we measure risk?
One of the challenges that a wider appreciation of ‘risk’ confronts is that of accounting for the vast range of possible outcomes within financial markets. Most financial risk management becomes a mathematical exercise in quantifying risk based on historical events. This exercise often polarises people. For some, the mathematics provides the only quantifying tools we have to compare the historical ‘riskiness’ of different investment returns.
However, calculating the probability of known historical events only tells us one thing: the probability of events that happened in the past. We cannot quantify the risks that may appear in the future and just as importantly, we cannot quantify the risks that did not appear in the past. Landing safely after skydiving without a reserve parachute does not prove that you will never need one.
Such arguments do not mean that evaluating risk is a futile exercise. Rather, understanding and managing investment risk is both a quantitative exercise and a subjective exercise of skill. The best investors use the framework that quantitative risk management provides to find opportunities that deliver better outcomes than random chance alone.
The risk and return trade-off
Unfortunately, the mathematics involved in quantifying risk is less straightforward than the mathematics used when calculating returns. If you bought a stock at $1 per share and it goes to $1.50 per share, calculating the investment return is a straightforward exercise. Few of us however, can calculate a standard deviation of returns figure in our head. Too often this means that investors overlook the importance of thinking about risk.
This is a great mistake. All the shortcomings that apply to quantifying risk apply in equal measure to quantifying returns. The first metric we all look at when assessing an investment proposition is what historical returns have been. A skilled investor is one who can form the same sorts of subjective assessments about risk.
The workhorse in most risk measurement exercises is the concept of volatility. In simple terms, the more volatile an investment is – the greater it moves up and down over time – the riskier it is as a proposition. In statistical terms, volatility is a measure of the dispersion of returns around a mean (a standard deviation). Fortunately, it is not necessary to understand statistical mathematics to be able to usefully apply this concept to your investing. Over the long-term, the volatility of global share markets has been 15%. In contrast, the volatility of global bond markets (a much less risky investment class) has been 6%. Long-run average annual returns for global shares have been 5.3%, while for global bonds they have been 3.9%.
Without needing to understand how volatility is calculated, with this information we are now able to put rigour into the idea that investing is a trade-off between risk and reward. The more volatile (risky) an investment is, the greater the returns needed to compensate for taking extra risk.
Taking these concepts to their natural conclusion is the Sharpe Ratio, which is the most widely used metric of risk versus reward in finance. It gives us a simple way of fairly comparing different investment propositions. It effectively shows the ratio of returns divided by their risk (volatility), with a higher ratio indicating better risk-adjusted returns than a lower ratio (a fuller summary of how the Sharpe Ratio works can be found here). Using the above example, the Sharpe Ratios for global share and bond returns are 0.23 and 0.38 respectively, showing that global bonds have delivered better risk-adjusted returns than share markets have.
For Australian investors, a worthwhile data point is that the long-term Sharpe Ratio of the S&P/ASX200 is 0.34.
Conquering luck
The bull market of the past few years has generated returns far greater than the historical long-run average share market return. Hanging over this is one of the most powerful forces in finance, the notion of the return to the mean. Recent double-digit annual returns are not likely to be sustainable in the long run. It is increasingly important for investors to distinguish between the quality of returns rather than only the absolute return numbers.
Many investors today would benefit greatly from a deeper understanding of the concepts of investment risk. In a rising market, an ability to beat random chance is easily overlooked. Yet ultimately, over the long run, the test of an investor is whether they managed to generate returns greater than the risks they took, not whether they made money in a bull market.
Miles Staude of Staude Capital Limited in London is the Portfolio Manager at the Global Value Fund (ASX: GVF).