Benel D. Lagua l November 30, 2023 l Manila Bulletin
Measurement plays an important role in our daily lives as they help in the performance of basic tasks. Measurement is the numerical quantification of attributes of an object or event which can be used to compare with others in the same category. Measurement tools are important in the finance field as it provides a scorecard to determine the success of an activity or event. And one critical area where finance has attempted to develop measurement metrics is in returns versus risk.
Financial analysts use various statistical methods as measurement tools for viewing returns and risk. For purposes of this column, we will confine ourselves to the basic measures of a central tendency (mean, median, mode) and measures of dispersion or volatility (range, variance, standard deviation). At its most elementary application, central tendency of a projection is used to depict return, while the dispersion measure is used to represent risk.
In a typical business case on managing returns, students are asked to compute the estimated returns for several alternative risky assets, with various states of the economy lined up together with the probability of occurrence. The expected return for each risky asset is then calculated on which basis, judgment is made on the best potential investment. As a secondary step, the students are asked to calculate the standard deviation and coefficients of variations of returns for the alternative investments. This next step is intended to measure risk.
Using these measures, we can illustrate the risk-return principle. The greater the risk that an investment may lose money, the greater its potential for providing a substantial return. Conversely, low levels of uncertainty are associated with low potential returns. In our example, computing for expected returns of say, four alternatives, will yield combinations across the investment options of higher means and high standard deviation and low means, low standard deviation.
When students are asked to choose, the reply will vary. The risk averse will choose the least risky, i.e. lowest standard deviation, while the confident ones will choose based on highest expected return or mean.
Note that the calculated expected means and standard deviations are based on a forecast assuming various economic scenarios. Do investments with high risks always result to better returns? This is not the necessary actual outcome. Nobody knows for sure. But the calculated risk return profile provides room for a rational, intelligent approach to decision making.
The challenge for students is to have an additionality mindset. To the layman, the appropriate question is “can I sleep well if I take the riskier option in order to eat better” when the expected outcomes are achieved. Avoiding risk altogether is not necessarily a good thing. Aiming for the big bang usually pose dangers if the costs are not well studied. The rationale for the measurement exercise is precisely to judge how much additional uncertainty one is willing to bear.
In the Philippines setting today, those who place their funds in a pure bank savings accounts are safe up to the P500,000 coverage of the PDIC. But the returns are unfortunately woeful, a fraction of 1% per annum. With inflation, one loses in purchasing power over time. Is there a time deposit that will pay better?
Serious investors should always aim to beat inflation to preserve the real value of their money. For example, bonds (government as well as corporate) represent one viable option. Is the return worth the commensurate risk? My view is that provided the investor willingly holds the bond to its full term, the payoff is relatively assured and fixed. Those willing to take a longer view can invest in equity, and stocks represent the high risk-high return alternative. In equity, returns are not assured but the upside is a lot higher for those willing to ride market volatility.
As a caveat, bonds are not risk-free. There are interest rate risk and reinvestment risk. And don’t forget default risk, even if rare. These risks play out when the bondholder takes a trading stance or consider selling before maturity. Bonds lose value when interest rates go up in relation to the promised coupon payment.
Risk tolerance/appetite, or the degree of losses which one is willing to endure must be well understood. The investor must have clearly defined investment goals. Age, beginning wealth, time horizon, and context all contribute to the investor’s risk tolerance. Aggressive investors emphasize capital appreciation rather than principal preservation. Moderate investors want to grow their money without losing too much. Conservative investors are not willing to accepting volatility in their investment portfolio.
Additional returns may require bearing new risk, but it can be worth your while. When you decide based on carefully considered metrics, you are investing intelligently instead of gambling or rolling the dice.
*** (Benel Dela Paz Lagua was previously EVP and Chief Development Officer at the Development Bank of the Philippines. He is an active FINEX member and an advocate of risk-based lending for SMEs. Today, he is independent director in progressive banks and in some NGOs. The views expressed herein are his own and does not necessarily reflect the opinion of his office as well as FINEX.)