Why High Returns Doesn’t Necessarily Require High Risk

A couple of weeks ago, I watched a TV segment called Money Mind on Channel News Asia. Within this particular segment, a graph was showed which plotted the relationship between the level of risk and the level of returns you can expect out of certain financial assets.

On the bottom of the graph, which was essentially a straight line, there was cash as it is deemed to carry the lowest risk and offer the lowest returns. On the other end of the graph were derivatives, futures and options. They were deemed as the highest risk instruments which gives the highest returns.

In other words, within this straight-line linear graph, there is the projected thought that taking higher risk would lead to higher returns. The thing is, I don’t believe that this line of thinking to be true when it comes to share investing. On a related note, my fellow Fool Ser Jing had once shared  how the misuse of options can be detrimental to our investing returns. This is a cautionary tale of how taking higher risk does not necessarily equate to getting higher returns.

Let me explain my thoughts further.

A higher degree of difficulty doesn’t earn you extra points

I’m not the only to carry the view I have. Investing maestro Warren Buffett also doesn’t quite agree with the line of thinking that taking higher risks can deliver higher returns. In fact, he once contrasted investing with the way Olympic diving was scored:

“But the interesting thing about business, it’s not like the Olympics. In the Olympics, you know, if you do some dive off the— on a high board and have four or five twists— on the way down, and you go in the water a little bad, there’s a degree of difficulty factor. So you’ll get more points than some guy that just does a little headfirst dive in perfectly.

So degree of difficulty counts in the Olympics. It doesn’t count in business. Now, you don’t get any extra points for the fact that something’s very hard to do. So you might as well just step over one-foot bars instead of trying to jump over seven-foot bars.”

Part of the idea of investing is to find companies which are trading at a share price which has an asymmetrical risk-reward scenario. This means looking for the “one foot bars” – the low-risk investments – with sufficient upside which can justify the attempt to “jump over the one foot bars”.

In this sense, I have discussed before how there might be an asymmetric risk-reward scenario at property management and development group, Hongkong Land Holdings Limited (SGX: H78). The company has stakes in 13 properties located in the prime Central Business District in Hong Kong and is currently trading below its book value.

The bottom line is that if the individual investor believes that the downside is limited and there is potential for good upside, then the risk involved is actually low while the potential rewards are high. This goes against the notion that the individual investor needs to take higher risk in order to get a higher return.

Foolish take away

Risk is not a dial which you can crank up when you want to derive more returns. Having a higher appetite for risk does not mean you have to take more risk.

When it comes to share investing, it is possible to find scenarios where there is lower risk, but higher potential upside. That is where we should spend our Foolish time on.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chin Hui Leong doesn’t own shares in any companies mentioned.