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Higher potential returns always come with higher risk

Written by Preet Banerjee

Wednesday, December 14th, 2016

Investors are always trying to find better returns, especially in a world of low interest rates.

And while most investors are acquainted with the notion that risk and return are related, it seems to be forgotten from time to time.

Higher "potential" returns necessarily come with more risk. The emphasis on the potential of higher returns means that they're possible, but not guaranteed simply because you take on more risk. There are countless simple examples that drive this home. An investor could buy shares in a small technology company, hoping the company becomes very successful and the investor profits handsomely. It's also possible that the company fails, and the investor loses all their capital. This is a simple concept.

But when we look at more complex examples, it seems investors may loosen their grip on understanding the relationship between risk and return.

From bonds to stocks

A prime example is the switch from lower yielding, fixed income investments into dividend-paying stocks. Investors may be tempted to do so in search of better yields, especially when investing larger sums of money with the intent of providing an ongoing income source. If you were collecting 2% on a bond, and a large, blue-chip stock was offering an annual dividend of 4%, that would certainly qualify as a higher return. So where's the extra risk in a company like that? Well, if the company cuts their dividend, not only would your income stream get cut, the underlying price of that stock would often take a beating as well. The market would see a cut in dividend as a sign of trouble, and the outlook for that company would deteriorate as well.

The opposite could happen as well. If the underlying company's business was improving, they could raise their dividend, and a resultant share price increase could occur. All this is not to say that a blue-chip dividend paying stock is better, or worse, than a lower yielding bond. They just have different risk and reward trade-offs.

The perfect investment?

Where risk shows up in other types of investments may be less apparent. There are certain types of real estate investments that have track records of high yield and almost no volatility in the payment of these fixed yields. An example would be a mortgage investment corporation, commonly referred to as a MIC. Essentially, many investors pool their money together and this pool of money is then lent out to borrowers in the form of mortgages.

With higher yields offered and some long histories of making these yield payments like clockwork, many people wonder if they may have found an investment that violates the risk and return framework that applies to all other investments. Could investments like these actually offer higher returns with less risk than similarly yielding investments?

The answer is no.

For example, if the end investor is getting a return of 6%, then the MIC is taking their money and loaning it out at rates higher than 6%. When mortgage rates for prime borrowers are substantially lower than that, why would someone who was borrowing money not opt for a lower interest rate loan somewhere else? The answer is that they represent a higher risk. That higher risk is reflected in a higher rate of interest on money they borrow.

As with any industry, when things are going well, these risks can pay off. But if things turn south and enough loans go bad, payments could be cut and capital could be lost.

Again, this is not to say that these types of investments are, on average, better or worse than the alternatives. The takeaway is that higher potential returns always come with higher risk, and sometimes that risk does not have a uniform appearance across investment strategies.

 

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