Monday, July 16, 2007

Stomach for Risk & Appetite for Returns - Part I

Faced with two investment options each carrying exactly the same level of risk, any rational investor would choose the option that offers a higher expected return. Unfortunately, in real life investment vehicles that are expected to yield higher returns also carry a higher risk. If you doubt this statement, simply re-consider the first sentence of this post: why would anyone accept more risk without the promise of a higher return?

This line of reasoning leads to an intriguing conclusion. If you see an asset class that is expected to generate a high return, your warning bells should immediately go off. Even if the promise of a higher return is real, it no doubt carries more risk than an investment option that promises a lower return. This is clearly true of individual stocks, bonds and other investment vehicles, but is it true of entire markets?

My father met with a financial advisor last week. One of the many "excellent" pieces of advice my father received was to invest in the South-Korean stock market based on the dramatic returns that market has achieved in recent years. In fact, the South-Korean market tripled since January 2003. Never mind the fact that what the "financial advisor" proposed is simply performance chasing in its simplest and most dangerous form. If the logic I proposed above with respect to individual investment options holds true for entire markets, then the very fact that the Korean market has achieved such gravity defying returns is an indication of a very high level of risk that is attached to that investment option.

I am happy to report that my father declined the advice he was given. He did so not because of any argument that I made, but rather because he is a very risk averse investor. He understands his appetite for risk and invests his money in a way that allows him to sleep well at night. While he is far too conservative for my taste, he is a careful planner and knows exactly what he is doing. Kudos to him for that.

Today's post was meant to cover my mom's approach to investing, but I will postpone that discussion until tomorrow. My mom and dad have polarized investment strategies. It is amazing that they are able to share the same portfolio, but more about that tomorrow.

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