Why High Risk is Low Risk
8 July 2013
Ever wonder how Goldman Sachs or other big banks are able to make money almost every single day, trading or investing even though the market is volatile? Or how private equity firms that make risky start up investments are still able to generate positive returns year after year? Understanding the power of uncorrelated returns or income streams as a way to reduce risk in addition to potentially increasing returns will show you how.
What I discuss here is often used in investment portfolio management but can be applied to a variety of businesses. Investments could be stocks, companies or other types of assets or choosing between what clients to pursue for your business (anything where return and risk can be estimated). This article should highlight the importance of looking at how risks relate to each other within the business instead of individually. I will be using standard deviation as the measure of risk. The formula used to calculate the variance of a portfolio or group of assets is:
Coming back to the discussion of Goldman Sachs and other big banks, as seen in the above formula, as you have more and more income streams or different investments (higher n), the standard deviation or overall risk of the business income or returns is more dependent on the covariance between the different parts of the business than the risk in any one part. What all businesses can learn from this is that when managing the risk of your business its ok to take on higher risk projects assuming you are taking on other investments that’s success or failure is not related to each other. This allows for stable (and potentially higher) returns or income from an assortment of volatile or high-risk ventures. A more mathematical illustration of this point for the more mathematically inclined.
We at Broadgate Plantations are looking at an agricultural project in Cambodia (Terra Firma) . Our current income streams have a standard deviation of 20% and an expected return of 10%, while the agricultural projects income has a standard deviation of 30% and an expected return of 15%. Normally we would not be comfortable with such risk so we would reject this investment however this would be a mistake. However we are looking at how the returns of the agri investment relate to our other businesses in terms of correlation and then make a decision. Though correlation is by no means a perfect measure you should be able to create some sort of range of correlation between the assets. Assuming our current projects and the agri project have a correlation of .5 (1 means move exactly together, -1 means exactly opposite) then the standard deviation of the investments together only increases to 21.8% while your return increases to 12.5%. Without the agricultural project we earn 1% of return for every 2% of risk. By investing in the agricultural project, we will now earn 1% for every 1.74% of risk. Assuming we can find an investment proposal that has no correlation with our current income streams, the results are even better; for the above example that would mean a standard deviation of 18% while getting a 12.5% return. Due to no correlation between the assets, the standard deviation or risk is lower for us as a result of investing in a riskier investment and returns are increased.
The importance of the approach showed above is that it changes the traditional idea of avoiding a high-risk investment or ranking various investments by the return proportional to risk. Businesses instead need to look at how the additional risks affect the business as a whole; with this approach even the addition of high-risk investments can lower the overall risk level of the business as a whole.
Assistant Securities Analyst
Broadgate Investment Advisory Securities (Thailand) Ltd
The views and opinions expressed in this article are those of the authors and do not necessarily reflect the official position of The Broadgate Financial Group.