Suppose you’re offered a choice of two investments. We can’t predict how either one will perform, but based on their characteristics the performance we would expect on average from the two investments is the same, but one carries a greater likelihood of truly superior performance. Which would you choose?
When you understand investment risk well enough to respond confidently with the correct answer to this question, you’re far ahead of the typical investor.
Another comparison
We can shed light on the question by asking another one. Once again you’re choosing between two investments with the same average expected performance, but one has a greater likelihood of falling rapidly in value, producing a large loss. Which will you choose this time?
Many investors will respond to the first question by choosing the investment that gives them a better shot at superior performance, while answering the second by saying they would avoid the one with the greater chance of a large loss. Yet these area actually two different ways of asking the same question, and the investment that seems attractive in the first one is the same as the one we’d like to avoid in the second.
This is not due to some abstract correlation discovered by academic researchers. It’s true by definition. If both investments have the same average performance, the only way one of them can offer more superior results is if it also offers more inferior results.
Deeper message
If you’re thinking this is just a trick question, you’re half right. It is a trick question, but it isn’t just a trick question. There’s a deeper message here, and it’s an important one.
Investors who lack professional training tend to think in terms of an investment’s normal performance and the possibility of exceptionally good performance. When they hear the word average, they think normal. When two investments have the same normal performance and one more often breaks out with exceptional performance, it’s reasonable to prefer the one with the greater upside.
Professionals look at investments differently. An investment has an average performance, with results above and below that level balancing each other out. And it has another important characteristic: a tendency to either stay close to that average, or to vary widely from it. The extent to which an investment can be expected to vary from its average is usually expressed in a number called the standard deviation, which you may have encountered in a math class that covered statistics.
A higher standard deviation means greater risk, because there’s a higher probability the investment will fall far below its expected value. But it also means a higher probability of outstanding performance. The two go together, yin and yang.
So which is better?
If two investments offer the same average performance, but one has a greater spread of highs and lows, it might seem that you can reasonably choose either one: go for the lower standard deviation if you don’t mind boring performance, or take the other one if you prefer the chance of higher returns and are willing to accept more risk of loss.
Yet two investments with the same average performance and different standard deviations are not equally desirable. The one with the higher standard deviation is an inferior investment. Investors who are willing to take more risk are normally compensated with higher average returns. When you take more risk without getting a higher average return, you’re taking uncompensated risk. In effect, you’re leaving money on the table. Good investors seek to minimize their uncompensated risk.
This is the first in a series of articles expanding on the discussion of investment risk appearing in my book That Thing Rich People Do.
Tags: investment risk
Kaye: I agree that an individual investment is inferior if it has an equivalent expected return, but a higher standard deviation. (But I would assert that the market prices investments such that their expected return is always appropriate for their standard deviation).
Nonetheless, don’t overlook the tax loss harvesting angle when investing. You would prefer to put together a portfolio of higher standard deviation stocks, where the diversification effect lowers the portfolio standard deviation. This is because the higher volatility provides more opportunity for tax management. You can tax loss harvest your losers. And you can donate shares of your biggest winners to charitable causes or (in more limited cases) to your children.
Even if the two portfolios have the same (pretax) investment return expectations, the one with more tax management opportunities will provide a higher after-tax return.
And that is also what Rich people do.
Excellent comment, and I’m currently working up materials on tax loss harvesting, although it may be a while before they’re ready to appear here. However, the parenthetical remark in your second sentence overlooks one of the key insights of investment theory in the 20th century: standard deviation that can be diversified away isn’t rewarded with a higher expected return. This is why failure to diversify produces uncompensated risk. But this is anticipating a later post in this series.