Does high risk cause high returns? Remember, correlation is not causation, and confusing the two has got many in trouble. Let us examine the cause-and-effect relationship of the ups and downs of the economy first before I proceed to explain the cause of high rewards. For simplicity, I will use one or two factors. However, in most cases, the multiple dynamic factors contribute to the outcome. An increase in the interest rate will cause the cost of the loan to go up and slow economic growth. In turn, it will reduce the growth and revenue of some of the businesses, and the value will decrease. On the other hand, an increase in profit and growth rate of the enterprise will cause the value to increase. 

Figure 1: Classification of Risk and Return

The risk of default is higher when the value is low. Also, if an asset price goes up, the risk increase, and the gain will decrease. During the dot-com bubble, investors who bought overvalued stocks incurred huge losses. To avoid misfortunes like these, intelligent investors seek to analyze and evaluate evidence of high-quality businesses. They take time to verify if the company is managed well and has a track record of profitability and growth. They also buy quality stocks at a fair or discount price to reduce risk. As a result, they earn high returns at low risk. Similarly, investing in underpriced quality real estate has low risks compared to overpriced or low-quality assets. Indeed, minimizing the probability of adverse factors will help to maximize value. 

High risk does not cause high rewards. However, the greater the challenges one must overcome to achieve greatness, the higher the rewards. To achieve anything extraordinary, one must persist and persevere. For something radical, the risk of failure to succeed with few attempts is high. But success or failure with every trial, one will still learn much more. The valuable lessons can propel one forward.

Success requires one to master the art of focusing on a goal and maximizing the value of big wins. Learning from data and experiences and use insight to create a better strategy to achieve the goal. Depending on circumstances and on a level of uncertainty, some may choose to make small bets to gather more evidence. As the unknown becomes known, as soon as the participants start participating in economic activities in the real world, they adjust as they see fit. In essence, excellence is achieved by those who have the fierce resolve to overcome challenges and maximize the value of their capabilities. Great investors, inventors, athletes, leaders, and high-performing organizations overcame challenges to earn high rewards.

Our world changes, and every new strategy or product feature after a while becomes a norm. As competition stiffens, it becomes harder to profit from old ways. Hence, to overcome the limitation of maximizing value, one must overcome the challenges and find new ways to maximize value. Warren Buffett, who has a track record for beating the market, continues to adapt his investing style to the changes in the world based on the goal he is trying to achieve. His strategy has evolved from cigar butts to quality assets investing. Note, the criteria for quality assets change over time. And success is a journey of continuous reinvention.

As Charlie Munger would say, invert always invert. So, I ask myself, what will cause one to lose most of the capital invested? High risk that can lead to severe or catastrophic outcomes. In essence, serious risk causes huge loss or harm. Thus, to maximize gain, one must also manage the risk. The adaptive model to maximize value and manage risks will help the investor to take actions that will help to minimize adverse conditions and maximize value. In other words, the model will help the investor to make informed decisions, reduce the risks and maximize value in a changing world. The ideas behind the adaptive model to maximize value and minimize risk are:

1. Understand the value and risks of assets.
2. Buy assets at a discount or fair price that are likely to maximize long-term value.
3. Embrace evidence-based decision-making.
4. Adhere to adaptive risk management and opportunities exploration.
5. Prioritize the quality of individual underpriced assets in a diversified portfolio over quantity

Figure 2: Adaptive Model to Maximize Value and Manage Risk of an Investment

The one who has the valuable insight and acts upon it in advance has an advantage. The adaptive model considers the economic forces that influence the outcome and feedback. Please note, the contributing factors to the result are vital for the correct interpretation of the information. They also help to forecast the impact of contributing factors. Hence, the ability to take corrective actions to minimize the adverse conditions and maximize value. Despite that, the commonly used statistical measurement for fund risk: Beta, correlation, standard deviation, and Sharpe ratio ignores causation. They are lagging indicators that consist of the upside (gain) and downside (loss) of the volatility. Beta (risk factor) is also a statistical measure relative to the S&P 500 index. Other models use downsides of the volatility without causal connection or account for compounding gain from the upsides.

For example, the Sharpe ratio, measure for returns to variability, will not help investors to be proactive. Also, the higher Sharpe ratio does not necessarily translate to higher returns. Despite that, the absolute inverse of the Sharpe ratio (volatility to returns) is a risk indicator for a short-term investment. In engineering, we have something like the Sharpe ratio called signal to noise ratio (SNR). We estimate SNR by measuring the noise of the device and the received signal that contains signal and noise. Like devices or environments, humans are not perfect. Therefore, we can conclude the price movement (output) has financial signal and noise. 

If the goal is to maximize the long-term value of quality securities and economic forces are in your favor, ignore the noises. You see, in the stock market, there are investors and traders with different goals, reasoning, and experiences. While some trade on the noise, others use signals. Some try to short sell the stocks and incur huge losses. You also have traders that look for quick gain, but in the end, minimize their return at high risk. The bottom line is the risk for short-term securities investments is high compared to long-term investment of quality securities bought at low prices.  It is also high for those that have limited information, buying distressed securities or derivatives.

End-to-end risk management is a must to maximize value. A key to remember is the odds of success are 50/50 without evidence or by relying on quantified price movement information only. The less evidence one has, the larger the blind spot and therefore the higher the risk. Indeed, the risk is much higher for those who ignore the evidence and choose to justify their incorrect assumptions. For them, catastrophe will hit harder, and a lot of luck may lead to high rewards. Investors can reduce blind spots through evidence-based decision-making. Since incorrect assumptions cause poor costly decisions, investors should use evidence to validate or invalidate assumptions. They should also use evidence to identify, assess, and reassess potential risks and opportunities.

The odds of success are about 80/20 for people who rely on evidence to create the strategy to minimize losses and maximize the value. The odds of success can go up more if investors have the right insight, temperaments, and skills. A strategic asset allocation and diversification instead of quantity will also help maximize value. While alternative asset classes may be uncorrelated to stocks, some have high risks with low returns. Likewise, the companies in financial distress have a high likelihood of failing during hard times. On the other hand, the companies that are managed well with high performance in the booming industry are likely to do well in good and hard times. The securities of quality companies at fair or discount are likely to maximize value.

As a side note, high risks (high beta), high returns can be traced to the CAPM model. The assumptions in CAPM include efficient market and rational investors. However, some investors are willing to overpay for stock during the boom and sell low during the bust. Other irrationality in the market includes the bandwagon effect of buying anything dot-com, blockchain, popular, and stocks of the companies that have filed for bankruptcy. Moreover, the estimation of beta assumes linearity and stationarity. However, stock and portfolio are non-stationary time series. Stochastic models are suitable for this kind of time series. Last, the distribution of the S&P 500 index and other portfolios is not normal.

Below are CRSOX and S&P 500 negatively skewed distributions for 2005 - 2021.

Figure 3: Probability distribution of daily returns for CRSOX and S&P 500 index funds (2005 -2021)

On the left side below, Credit Suisse Commodity Return Strategy Fund Class I (CRSOX) has a 5-years beta of 0.96, and GE has a beta of 1.01 from yahoo finance. On the right side, Invesco QQQ Trust has a 5-years beta of 1.03, and Apple beta is 1.21. According to CAPM, a portfolio with low beta has low risk. However, if you look at a graph of CRSOX, you will notice it is zig-zag downwards more compared to the market. In addition to having low beta, CRSOX does not contain any stocks. The fund comprises fixed-income securities, commodities-linked derivatives, and cash. 

Figure 4: On the left GE (beta=1.01) & CRSOX (beta=0.96, Sharpe ratio=0.22) with market risks that are not captured by beta and on the right Apple (beta=1.21) & QQQ (beta=1.03, Sharpe ratio=1.38)

S&P 500 index comprises the most popular stocks based on market capitalization. Its composition change with time. QQQ, USMV, MSFT, and Apple influence the price movement of the S&P 500 index. On the other hand, CRSOX and many others do not. There are also stocks with the negative beta, and volatility and correlation change with time. Some portfolios and stocks have low beta and high gain and vice-versa. In essence, both low and high beta can have either high gain or low gain. Below is the plot for USMV with a beta of 0.75 and Microsoft with a beta of 0.79. 

Figure 5: MSFT and USMV have low beta and high returns

While some may assume a portfolio with bonds will perform better during the recession than the one with stocks, in this case, CRSOX zig-zag downwards. In 2008, 2011 – 2015, 2018, and March 2020, CRSOX prices spiral downward more compared to S&P 500 index. That means CRSOX has underlying conditions that pose risks not captured by beta, which is measured relative to the market. The problem, in this case, S&P 500 index fund is not a good benchmark for funds that do not contain stocks. In other words, different combinations of factors influence the risks and value of two non-stationary time series. So, if you ignore causation, you increase blind spots and hence the risk.

It makes sense to interpret the statistical information within the context of the underlying conditions of the assets in the portfolio. The case-by-case assessment of the risks and value of any investment, class of assets, and industry sector is a must. So, investors need to assess the probability of occurrence of factors that influence expected returns or risks. For risk, one can estimate the likelihood of unfavorable conditions and the rough estimate of the potential loss. For example, the probability investor will buy at the peak and sell at the trough of recession given the investment strategy. Similarly, one can estimate the possible value given the probability of a set of favorable factors.

Note, the coin of portfolio returns has a loss and gain side. While risk is the probability of loss, value is the gain. Given the likelihood of loss increases with adverse factors, the investor needs to control the risk and explore opportunities to maximize value.

4% account for fees of fund A and inflation rate. Fund A has high fund fees compared to the other three funds. Every asset in the portfolio has its underlying risks that change with time. As the factors change, the probability values will change.

Figure 7: Probability of loss and gain for different funds on a given period

All in all, the events and behaviors of the stakeholders will influence the outcome. While the COVID-19 pandemic has created opportunities for companies that sell essential products to maximize value, it has also increased the risk of failure for others. Unlike other recessions, most stocks are overpriced, and volatility is high on the market. Despite the stimulus, some of the companies at risk will file for bankruptcy. 

Figure 8: Risk of different stocks

The statistical measures (beta, standard deviation, correlation, etc.) are not good risk metrics for the portfolio (nonstationary time series). And lagging indicators will not help investors to be proactive. But understanding contributing factors will help to interpret the meaningful metrics correctly. It will also allow investors to reduce the adverse factors on the portfolio and maximize value. Thus, as the world change, the portfolio composition can change to reflect the changes. In essence, the adaptive model to maximize the value that embraces strategic risk management is vital to increase the odds of success in a changing world. It allows investors to focus on the goal to maximize value and minimize the risk. To ignore the noise, pick up the signal that matters, and take corrective actions. Hence, the ability to achieve the desired outcome.

Glossary

D/E: Debt to Equity

PE: Price to Earning

PS: Price to Sales

ROE: Return on Equity

CAPM: Capital Asset Pricing Model

Cigar butts: cheap low-quality securities

The price, beta and Sharpe ratio are from yahoo finance (June 2021).

The 5 years financial values are from financial modeling prep (2016 -2020 or 2017 - 2021)