Rebooting from the Risk – Return and Disappointment theory

Back from the long Diwali holidays, time to reboot on the markets, long breaks are always good to revive and get blogsome thoughts from your near and dear ones.

On the way back from Bhopal to Mumbai, some fellow passengers were curious about the markets and the train was late as much as 6 hours. It was a holiday special train and passengers paid a premium to board the train compare to other routine trains, they expect the train to come on time as the fare is higher. I did exchange few tweets with the railways department for delayed train.

Getting back to the theory as the fellow stranger passengers did not have a good time with markets as well, most of them were trying to time the market.

I told them to see, stocks are stocks, bonds are bonds, and cash is cash. As an investor we expect 30% returns in stocks, 8% on your fixed deposits, bonds and cash depends upon the bank where the money is parked.

The minute we set an expectation for them to break this trade of risk for return, we’re setting ourselves up to be disappointed.

Let me break the silos and narrating a simple story:

Next to a mountain trail stood a twisted, gnarly tree. Hikers loved the shade it provided, but one day, a guy with an axe came along and decided the tree could do more than provide shade. He thought the tree would make a great table. So he chopped it down and hauled the tree to a carpenter.

Much to the man’s disappointment, the carpenter took one look at the tree and said, “This tree is too twisted and gnarly to be a table.” Now the hikers have no shade, the tree isn’t a table and the man with the axe is disappointed.

Investors make a similar mistake every time they try to make stocks feel safe like bonds or try to get bonds to generate big returns like stocks. Stocks, bonds and even cash are what they are. That doesn’t stop us from trying to change their nature though. More often than not, we end up disappointed because they fail to meet our expectations.

The closest thing we have to a universal rule in finance is that risk and expected return are related. Once we’ve got a diversified portfolio of investments, we must take greater risk to get a higher return. Risk is mainly a function of how wildly the investment you own fluctuates in value. In other words, in order to get a higher return, we need to deal with something going up and down. Sometimes a lot. That’s the deal we make with the markets, and there’s no real way around it.

If we understand the nature of stocks, bonds and cash and use them in a way that plays to their strengths, we can avoid a whole host of problems with our investing behavior.

A lot of our bad investing behavior comes from these unrealistic expectations. We’re shocked when the market goes down 20 or 30 percent, even though that is part of the deal. So, we start looking for a safe alternative to the low-interest rates we’re earning on our savings accounts. We buy some new product marketed to retirees as a way to get higher income without all the risk. Then, we end up owning a junk-bond portfolio that gets crushed the next time the markets change. Whatever the bad decision, it often stems from believing we can change the nature of this deal we’ve made with the markets.

Like the tree that provided shade for hikers, we have investment options that play a very specific role in our overall financial strategy. The best part is that once we accept them for what they are, we can use them to help us reach our goals without disappointment or frustration. We don’t need stocks or bonds to be something they aren’t once we understand exactly what they can do.

By the way the train was cancelled at Kalyan station, it was supposed to go till CST 🙂

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