Part Eight: What is the relationship between risk and return?

Introduction

This tutorial explores the relationship between risk and return as discussed by Howard Marks in the video by Oaktree Capital. Understanding this relationship is crucial for making informed investment decisions. Marks challenges conventional wisdom, providing insights that can help investors navigate risks effectively while seeking returns.

Step 1: Understand Risk and Return Dynamics

• Definition of Risk: Risk refers to the potential of losing money or not achieving the expected returns from an investment.
• Definition of Return: Return is the profit or loss made on an investment relative to the amount invested.
• Key Insight: Higher returns typically come with higher risks. However, not all risks lead to higher returns, which is a common misconception.

Step 2: Recognize the Types of Risks

• Market Risk: The risk of losses due to factors that affect the overall performance of the financial markets.
• Credit Risk: The risk of default on a debt that may arise from a borrower failing to make required payments.
• Liquidity Risk: The risk that an asset cannot be traded quickly enough in the market to prevent a loss.
• Operational Risk: Risks arising from internal processes, people, and systems, or from external events.

Step 3: Evaluate the Risk-Return Tradeoff

• Assessment: When considering an investment, assess the potential return against the risks involved.
• Practical Example: If an investment offers a 10% return but comes with high volatility, weigh that against a more stable investment with a 5% return.
• Tip: Use tools like risk-adjusted return metrics (e.g., Sharpe Ratio) to compare different investments quantitatively.

Step 4: Analyze Historical Performance

• Study Past Trends: Review how different asset classes have performed over time concerning risk.
• Learn from History: Understand that past performance is not indicative of future results, but it can provide context for potential risk-return scenarios.
• Common Pitfall: Avoid over-relying on historical data without considering current market conditions.

Step 5: Diversify to Manage Risk

• Diversification Strategy: Invest in a mix of asset classes to spread risk.
• Practical Steps for Diversification:
  • Include stocks, bonds, real estate, and commodities in your portfolio.
  • Adjust your asset allocation based on your risk tolerance and investment goals.
• Benefit: A well-diversified portfolio can help mitigate the impact of poor-performing assets.

Conclusion

Understanding the intricacies of the risk-return relationship is essential for successful investing. By evaluating different types of risks, analyzing historical performance, and employing diversification strategies, investors can make more informed decisions. As you consider your investment options, remember to balance potential returns with the risks involved to build a resilient portfolio.