Sure, everybody knows that with higher expected returns comes the bigger risk of loss. But time and time again investors put this most basic rule to the test in a kind of bull-market delirium. That explains the last blood-curdling year in investing, the last 15 years, and even the last thousand years.
This should be the first thing people absorb when they learn about personal finance and are introduced to investing. But for some reason (greed?), even people who work in finance often ignore it. Understanding the risk/return trade-off is also the best way to protect yourself from financial scams. If anyone ever promises you they can beat the market, one of three things is true: they are lying, they don’t know what they are doing or they are charging very high fees and it’s not worth it.
The fact that there is no free lunch in finance underpins modern financial theory. No matter what new innovations come our way — high frequency trading or the blockchain, for two — it will still be true. Just look at the last few years. In 2020 it seemed like anyone could beat the market. You just had to pick the right assets (maybe crypto or tech stocks, which were offering very high returns and making lots of people rich). And TikTok was full of people offering advice on how to pick sure winners.
Now, whatever looked great in 2020 and 2021 is underperforming. Since January last year, the S&P is down 20%. But if you took on extra risk and bet on tech, your portfolio would be down 45%; If you bought crypto it’s down 64%. The only asset class that claims to be doing well is private equity, but that’s also risky because it’s illiquid and funds have so much leeway to calculate returns (since they are not sold in the market), so there is no way to know if those high returns are even true.
And this is normally how it goes. The riskiest investments tend to do better in bull markets and much worse in bear markets, and a down market is the worst time to lose money because everyone needs money then and your job prospects are worse. So if any asset you invest in is doing better than the rest, odds are it isn’t because you made a great bet, it’s just that you took on more risk.
Yet we easily forget this hard truth. Perhaps because many of us know someone who got rich on crypto and sold at the right time. That is the nature of risky markets, if you time it just right you can come out ahead, but getting the timing right is rare and even if you do it once, odds are you won’t be able to do it again. Many people who called the 2008 financial crisis have never repeated their success — or luck.
Now that we’ve established the simple risk/returns rule, it’s important to understand that there is nothing wrong with taking more risk. If you do, you will probably get a higher return over time. Higher risk doesn’t mean big losses are inevitable. You just have less certainty. The problem, whether it’s the housing bubble, the FTX crypto exchange, hedge fund Long-Term Capital Management LP, or any other financial disaster, is when people take on lots of risk and present it as (or wrongly believe that it is) risk-free.
Big financial blowups happen when someone thinks they have a risk-free bet that will beat the market, and to make their return even bigger they take on extra leverage, borrowing to finance their “sure thing.” Leverage makes everything bigger, returns and losses, so when the “sure thing” loses money it can be catastrophic. Even leverage is not inherently bad. The real problem is thinking something is risk-free that is in fact risky, and then doubling or tripling down (or more) on that bet without accounting for the potential downside.
Anyone who works in financial services should know better, and yet they so seldom do. Maybe that’s because it’s just too easy to believe you are smarter than the rest, and when the market is up and so is your portfolio, it can look that way. But it’s not true. If you are beating the market, you are risking a bigger loss, and it will probably happen at the worst possible time.
If you can afford that loss and have the mettle to ride out down markets, then it can eventually be a worthwhile tradeoff. If you do pay for advice, it should be for risk management or retirement planning, not beating the market.
In 2023, if you want to do it yourself, then think about balance: Take on some risk, but not an excessive amount. For most of us, that might mean an index fund that invests in a lot of stocks and charges low fees. Then you limit your exposure to only that market risk, which is spread across more companies. Even after 2022’s down market, the S&P 500 is higher than it was three years ago. The same isn’t true for lots of riskier investments.
Allison Schrager is a Bloomberg Opinion columnist covering economics. A senior fellow at the Manhattan Institute, she is author of “An Economist Walks Into a Brothel: And Other Unexpected Places to Understand Risk.”
This content was originally published here.
