Risks versus Returns: an explainer

At Lendahand, people can invest in local partners (banks and non-banking financial institutions) or directly in entrepreneurs. The returns on these investments now range between 2.5% and 8% per year. That’s quite a difference. But what price is being paid?

Free Lunch

If you ask professional investors who manage large portfolios what the most important factor is in assessing the relative attractiveness of a financial instrument, there’s a good chance they will say: the risk, or in other words, the volatility.

You might expect them to mention “expected return,” but the accepted theory is that return is a function of risk. William Sharpe won the Nobel Prize for this observation (maybe CAPM rings a bell). The risk-adjusted return measure named after him, the Sharpe ratio, is also widely used by institutional investors.

In addition to Sharpe, such as Markowitz, other Nobel Prize winners have formalized the relationship between risk and return. The conclusion is always the same: in the long term, risk can only be reduced – without sacrificing expected return – if investments are diversified. This is also known as the only free lunch in finance. Adding a risky investment to your portfolio can lead to reduced portfolio risk, depending on the correlation of that investment with the rest of your investments. And the more you can diversify, the better.

Are you still with me?

Risk Reduction

Apart from diversification, you could view return as the price paid for taking on a certain risk. For example, this could be the risk of depositing money with ABN AMRO, where if the bank collapses, the government might not be able to activate the deposit guarantee scheme. A very small risk, and therefore a relatively low return.

Further, along the risk-return spectrum, you’ll find opportunities to invest (for example, through Lendahand) in solar companies in Africa. Read here why that’s a great opportunity and why it shows a different risk-return profile. You can receive 8% interest per year for some of these projects. However, it’s a young industry with many unknown variables. The cards have yet to be dealt. A higher return is therefore consistent with the higher risk profile.

Three Tips for Investors: Diversify, Diversify, Diversify

So, you can sit back and save with one of the major banks in the Netherlands, invest in a solar company in Africa, or choose something in between on the risk-return spectrum. For example, investing in bonds from a foreign bank that is supervised by the national central bank there, has been active for a long time, and has a substantial loan portfolio. Such an investment implies relatively lower risk and, therefore, justifies a lower interest rate. Of course, with a foreign bank, there is always the chance that you could lose your investment entirely. After all, there is no deposit guarantee scheme.

Theoretically, as long as risks are fairly priced, one should be neutral towards investing in a party with a low-risk-return profile versus a high-risk-return profile. In fact, as described above, the free investable capital should be spread across many different profiles and offerings. It is advisable always to keep a responsible portion as savings and invest the rest in a diversified investment portfolio.

Conclusion

It’s not wise to always go for the projects with the highest interest rates. Again, diversification is the only free lunch, and if the interest rates accurately reflect the risk, you would typically also want to invest in parties offering lower interest rates.

Of course, there are exceptions: a handful of people can consistently beat the market through cherry-picking the right investments. But be careful. To quote John Keynes:

“The market can stay irrational longer than you can stay solvent.”