Maximizing Returns While Minimizing Risks: A Guide To The Risk - Return Spectrum

Investment is where faith meets calculation in preparing for the foreseeable future. Analogs of the investment process appear ubiquitously, from biology where organisms consume part of the energy they produce to create offspring, to the expansion of cities, where municipal governments take a portion of last year`s revenues and apply it to this year`s operations to facilitate growth.

The Three Phases Of The Investing Process

Formal investment involves three distinct phases. First, value must be converted to portable form (money), then transmitted to a receiving entity for a dedicated purpose, and then returned to the investor according to an agreement among the parties.

Each of these phases entails a certain type and amount of risk. There is risk in converting assets to money (conversion risk, counterparty risk, liquidity risk). There is risk in holding money as money (inflation, geopolitical risk, currency risk), there is risk in owning the asset (liquidity risk, economic risk) and there is risk in being repaid (counterparty, liquidity, conversion, geopoliticall).

Crafting A Viable Risk Profile

In evaluating which investment types belong in a portfolio, the most important element is the risk component. Identifying particular risks and crafting a specific risk profile for a portfolio is therefore of paramount consideration. Once a risk profile has been established, the investor can know which categories of investment are most advantageous for maximizing potential returns relative to that risk.

Once a portfolio`s risk profile is shaped, the manager knows which risks are not to be taken, and the positive elements of the portfolio can be installed. Several questions must be answered in making these determinations, such as what are the specific characteristics of not only this type of investment but this particular vehicle within that investment category, what happens if things don`t go to plan, how does a particular vehicle tend to behave in various environments, what costs does it feature, and what is, or can be, the exit strategy? These represent the finer points of crafting a portfolio, in achieving the goal of maximizing return, or alpha, subject to the constraint of a predetermined risk profile.

Categorizing Elements Of The Portfolio

Elements of a portfolio can be the investments themselves, such as a stock or piece of property, or other entities which contain or combine their functions, such as mutual funds, REITS or limited partnerships.

1. Equities: Medium-High Risk, Medium-High Reward

Equities, or stocks, are one of the most volatile investment categories, and so offer the potential for high returns over the long term. However, due to their higher risk, investors must be prepared to accept the possibility of significant losses. Equities should be a core part of any portfolio in order to maximize returns and diversify risk. Equity securities are at their core a claim on the earnings of the issuer, so the health of that issuer is of paramount concern. Additionally, there are liquidation preference issues with equity; in the unfortunate event of liquidation, senior debt holders are paid first, then junior debt holders, then preferred equity holders, then common equity holders. In bankruptcy, equity holders rarely are made whole, or even part.

2. Fixed Income: Low Risk, Low Reward

Fixed income investments, such as bonds, notes, and debentures, offer lower returns than equities but with a much lower risk profile, owing to the issuer`s calculated ability to repay the debt. The returns on these investments are more consistent, but also tend to be lower, due to this degree of certainty. Fixed-income securities come in many different configurations, allowing investors to combine and trade them to achieve very specific and finely-grained risk profiles. Investors looking for a stable return should consider investing in fixed-income securities.

3. Commodities: High Risk, High Reward

Commodities are a risky but potentially lucrative investment. These investments tend to be very volatile and can be subject to large price swings. These swings can in turn be magnified by the high leverage. Investors looking to make a quick return should consider investing in commodities, but it is important to be aware of the associated risks.

4. Residential Real Estate: Medium Risk, Medium Reward

Real estate can provide a steady return over the long term if managed properly. Investing in real property can provide a steady cash flow, but can also be subject to significant price fluctuation. Since most investors generally seek to minimize their investment of funds while maximizing their borrowings, leverage tends to be higher than with more liquid portfolio elements. An investor can reasonably put 5% down on a piece of property, which implies 19:1 leverage (you`re putting down 1/20 of the purchase price, the other 19/20 are borrowed, hence 19:1 leverage). This means if prices decline quickly, they can wipe out this 5% equity quickly. Those 19 can quickly overwhelm the 1. By the same token, a 1% annual price increase can increase equity by 19%.

5. Alternatives: High Risk, High Reward

Alternative investments, such as private equity, venture capital, and hedge funds, offer higher returns but with a higher variance in their returns. These investments are usually not liquid and require the investor to be patient in order to reap rewards. Although risks are different in the alternative space, this doesn`t in itself mean they are higher, per se. Ignorance of any investment space is its own risk. Investors looking for high returns should consider alternative investments, but must be aware of the associated risks, and harness the power of these vehicles in an optimal way that contains these risks.

6. Commercial Real Estate: Medium Risk, Medium Reward

Commercial real estate offers investors a steady return with a lower risk profile than equities. CRE investments can offer some of the best return-to-risk ratios in the investment world, due to the creditable nature of their clientele, as well as the leverage they employ. The returns are typically steady and consistent, and the risk is often spread across many different properties in the same investment vehicle, such as a REIT or other corporate entity. Commercial real estate is a great option for investors looking to diversify and solidify their portfolio while still achieving returns commensurate with the risk of loss. Commercial real estate offers a risk profile similar to that of equities, but with greater potential leverage, and much lower liquidity.

7. Exotic Business Models: Lower Risk, High Reward

Today`s business landscape lends itself quite well to extreme creativity and can even reward certain levels of complexity over relative simplicity. If we acknowledge that creativity often entails the recombining of ideas, concepts or risk and reward in different ways, today`s tools enable many paths to profits that would have been uneconomical in earlier times. Understanding, for example, that SaaS (software as a service) products can be white-labeled and marketed to niche businesses for finely-tailored results could give an investor a decided advantage over others who might not see the opportunity to recombine existing ideas in such a profitable way. This category offers nearly unlimited opportunity, with lower risks due to new tools which make experimentation prior to scaling relatively painless and informative.

Conclusions

In summary, different investment types carry with them specific types of risk that lie, more or less, along a continuum. Within those investment types lie various ways of combining these risk profiles so that they correlate in ways that reduce overall risk, while maximizing alpha, i.e. the portion of an investment`s return that is excessive to the risk incurred.

By first shaping a portfolio`s risk profile, then adding less-correlated risk elements, the overall risk of the portfolio can be contained to a known quantity, and the return potential optimized against this figure, to generate alpha, or excess return for the risk incurred.