One universal truth seems to be that you can’t get high returns without taking on high risk. Risk and return are correlated, right? Stashing your money in an Ally savings account is considerably less risky than investing in biotech stocks and you can expect to be compensated accordingly. But is all risk worth it? What about uncompensated risk?
ARE YOU TAKING ON RISK FOR FREE?
There is a difference between compensated risk and uncompensated risk. If you choose to take a compensated risk, it will increase the expected return of your investment (although the return is not guaranteed).
What’s an example of a compensated risk? The same as stated in the intro paragraph: if you invest money in stocks rather than putting it in a high-yield savings account, you’ve increased the expected return of your investment by taking on the performance risk of the underlying companies.
Investors are compensated for taking on greater risk because the investment returns are volatile. Demand for “volatile” investments is less than demand for “certain” return that could be expected from saving money in a savings account. Lower demand leads to a lower price, which gives you the opportunity (not the guaranty) for a greater return.
Why would anyone ever take on uncompensated risk?
That’s a great question. An uncompensated risk is additional risk for which no additional returns are generated.
It doesn’t sound like a good deal to me.
One example of an uncompensated risk is a risk which you can eliminate through diversification.
In other words, when people write about the reward of taking on risk, they are talking about nondiversifiable risk.
For example, you could invest your entire portfolio in General Electric. For the sake of argument, let’s assume that the market expects General Electric to perform equal to the entire stock market at 5% growth per year (after all, GE is a blue chip stock).
Is it more or less risky to invest your entire portfolio in one single stock vs investing in all 6000+ stocks in the stock market? Of course it’s risker to invest in GE!
Given that you’re taking on the additional risk, you should be compensated for it, right? That’s the way it works. More risk = more reward!
Nope. That’s not how it works.
You won’t get any additional return by taking on the risk of investing in a single stock vs investing in the entire market.
Why? Because the risk is easy to eliminate through diversification. If it’s easy to eliminate the risk, it’s not really all the undesirable is it?
If the risk is easy to eliminate, the risk has no impact on the demand curve (i.e. an investor is indifferent to the risk because they can eliminate it, so there’s no reason for them to seek a “safer” investment).
Another example of nondiversifiable risk would be investing in one income producing rental property vs investing in a REIT. Is it riskier to invest in one property vs investing in 1000s of property? Of course it is! Are you compensated for taking this risk? No, because it’s easy to avoid through diversification.
HOW YOU CAN MAKE MONEY UNDERSTANDING UNCOMPENSATED RISK
By understanding that the market only rewards risk which can’t be avoided, you can set yourself up to maximize returns while eliminating risk.
We’re all familiar with the story of the investor who put all his eggs in one basket. Maybe it’s the tech guy that kept all his portfolio in his company stock. Maybe it’s the friend that had thousands of dollars in Enron because it was a sure thing. Don’t be that investor! Avoid uncompensated risk by diversifying your portfolio.
Don’t look for the needle in the haystack. Buy the whole haystack. – Jack Bogle
If you’re not going to be compensated for risk, why take it?
Let’s talk about it. Are you taking on uncompensated risk? Why or why not?