Risk and return on investments: Understand the inseparable connection

Every investment decision is ultimately based on two fundamental, fundamental questions that are of central importance for every investor, every bank, every financial advisor and everyone who wants to invest their assets: Firstly, what returns do I want to achieve with my investment? That means: What income do I aim for to grow my assets or at least preserve them? andSecond, how much risk am I willing to bear under this investment to achieve this return? These two questions seem to be separate at first glance – one according to the desired return, the other after personal risk tolerance. But on closer inspection, it turns out that they form an inseparable unit. Because, it can be statedit is two sides of a coin that are mutually dependent and can hardly be separated from each other. It is a mistake to look at these questions separately because they are in reality a complex unit that only allows a meaningful decision together. This connection is crucial for any investor who wants to build up long-term wealthMeaning: The relationship between return and risk is not a simple, linear comparison, but rather a close connection that can hardly be separated in practice. Only those who understand the mechanism of this connection – especially the so-called risk premium – are able to make rational, well thought-out decisions. The goal is to balance the balance between yield and riskto manage in such a way that personal risk-taking is not exceeded, but at the same time the desired return remains achievable.

The illusion of simple risk assessment

Despite this undisputed connection between risk and return, many investors, financial advisors and so-called “Roboadvisor” try to greatly simplify the topic of risk. They fall back on so-called risk profiles, which are usually only described by terms such as “safety-oriented”, “conservative”, “balanced”, “opportunity-oriented” or “speculative”. These terms areOften only spongy and is primarily used for simplification. They leave the investor in the dark about what this category means and tempt many to make a choice without understanding the actual risks. In a sales pitch, the customer is usually only presented with a vague selection: There are five risk profiles he only uses a nameshould distinguish. The question “Which pig would like it?” is almost the program. It is obvious that the seller hardly explains in detail what this risk profile means in reality. Instead, the customer is often only tempted to choose a socially desirable, so-called “medium” or “balanced” because this is the least noticeable. This choice soundsreasonable, but is not meaningful in terms of content. What does “balanced” mean in concrete terms? What can I lose in bad times? How much is left after 20 years? There is mostly silence here. Because most investors, especially laypeople, hardly get a clear answer to these questions. It often remains with vague assumptions that hardly offer any actual orientation.

Short-term orientation and its pitfalls

In practice, short-term orientation is particularly pronounced in most investment decisions. The seller often only speaks of a term of three to five years without taking into account the long-term consequences. The investor is usually only given the choice between the different risk profiles without really preparing them for the consequences. The result: mostInvestors tap on the middle because “balanced” sounds best. That means: They usually choose the middle risk category without really dealing with the possible losses. As a result, the product you buy is advertised with a five percent commission and an annual administration fee of 1.8 percent. What “balanced” means in detail remains in thedark. What can I lose in the worst case? How much will be left after 20 years? Often the investor does not receive a clear answer because these questions are hardly answerable in practice. Instead, the discussion is directed to the supposedly safe, short-term profits. And in this context, the actual risk situation hardly plays a role.

The danger of short-term perspective

The problem is that most investors usually only look at the next three to five years. They want to know what is happening in the short term and are therefore hardly able to correctly assess the long-term risks. As a result, they often react in panic and sell their investments in times of crisis in order to prevent further losses. But this very reaction isBiggest mistake because it only exacerbates the losses. Most investors who pull their rip cord in a crisis later experience that the markets are recovering – only their deposits are left behind. This behavior is not an isolated case, but the rule in this risk management. It is the so-called “pension trap”: one tries to avoid risks, but the result is a permanentwealth deterioration. The paradoxical result: The pursuit of security often leads to permanent losses and thus to a permanent deterioration of the standard of living. This is a sobering realization that confronts many investors with a hard truth: In practice, controlling the risk is much more difficult than it seems at first glance.

Understand the risk better: risk premium and volatility

An important step in correctly assessing risks is to understand the mechanisms of the risk premium. This risk premium is the additional gain that investors expect to take a risk. Only if you understand why you are rewarded for the risk, you can make a rational decision. A commonly used term is volatility – a measure of risk,that measures the fluctuation range of an underlying within a certain period of time. Although volatility plays a central role in the financial sector, it is hardly understandable for the layperson. What does a lot of volatility mean? what little? What period does the number refer to? weeks, months, years? Is it historical or implicit volatility? These questions mostly remainUnanswered because the key figures are difficult to interpret. In addition, investors tend to consider the fluctuations normal, as the Gaussian bell curve suggests. But reality shows a different picture: the fluctuations increase significantly, especially in times of crisis. There are severe price slumps that significantly exceed the standard models of normal distribution. Therefore isThe volatility is only an approximate orientation that loses its significance in times of crisis.

The limits of risk measurement

The measurement of the risk based on volatility is therefore only an approximation. When it comes to the question “What does a one-year volatility of 28% in the DAX bring me?” the answer is difficult to grasp. It is hardly possible to determine the individual influence of this number on one’s own life plan. A better alternative is the concept of “Value at Risk” (VAR). this tries thequantify the likelihood of an undesirable loss in a given period of time. For example, with an annual VaR of 10% and a 95% confidence level, it is assumed that a maximum 10% loss is not exceeded with a 95% probability. But this model also has limits. It is often presented as if risks could be calculated and controlled exactlybecome. In practice, many fund managers fail regularly, for example during the first corona crash. A prominent example: A fund manager who praises this risk management almost exactly achieved the maximum defined loss within a short time – despite the marketing promises. Despite numerous explanations as to why early detection failed, thereality: The risk was misjudged. This is a disaster for investors. In order to avoid larger losses, the equity ratio is greatly reduced during the crisis. This is called the so-called “pension trap”. The result: While the markets are recovering, the assets of customers often lag behind. This is not an exception, but the rule in this type of risk management. the aspirationMaking risks fully manageable, paradoxically, leads to permanent losses of assets and a lower standard of living. First of all, this is a sobering finding that robs many investors of the illusion of being able to fully control the risk.

New perspectives: Recognize risk and return

Given these findings, it is worth looking at the topic of risk and return from a different perspective. Instead of just asking: “How much return do I want?” One should ask oneself above all: “For how much (expected) return do I have to accept high (potential) setbacks?” It is also crucial which risks are avoidable and which are hardly to be controlled. andUltimately, the following applies: How risky is it to do nothing at all?

Realistic assessment of the return and risks

The first responsible step is to know the actual, realistic returns. It makes sense to look at the historical data for the USA, as they offer a significantly longer database than Germany. The figures for the period from 1900 to 2019 show: In a globally scattered equity investment, the average inflation rate wasYield in these 120 years at only 5.2%. This may seem little at first glance, but on closer inspection this is a respectable number when considering the multitude of crises, wars, world economic crises, dictatorships, the Cold War, oil crises, dotcom bubbles, terrorist attacks and financial crises. Despite all the disasters, the assets have turned realincreased on average 5.2% per year. This shows that reality is rough, but not impossible, and that this return is quite acceptable in daylight. It is a sober insight that sharpens the view of the actual possibilities.

Assess the risks correctly: Find your own risk profile

The second step is to realistically assess your own risks. It is important to know and differentiate the risks of the individual asset classes: Which risks are systematic, i.e. market-related, and which are unsystematic, i.e. individual or industry-specific? In stocks and bonds – the most important asset classes – the unsystematic risks can beEliminate almost completely through broad diversification. This is a big advantage over real estate where the risk is concentrated on a single property. Overall, the capital market is not a zero-sum game: Those who invest cleverly can benefit from the power of the market, which has created an amazing creation of wealth over the past 200 years. The central principle:Free entrepreneurship, market economy and capitalism are the driving forces. Despite all the criticism of individual aspects of this system, the basic principle is functioning and without alternative. It’s basically simple: An entrepreneur needs raw materials, labor and capital for the production. These factors must be paid for in the long term: raw materials are bought, employees are paidAnd the capital is provided by investments. For the investor this means: He acts as a risk carrier, but receives compensation for the risk that the entrepreneur’s idea will fail.

The big trap: lose control and control

Here lies the great illusion: Many investors believe that by diversification and control they could control the risks as entrepreneurs do in their business. But that’s a big misjudgment. As an investor, you have no influence on the companies you invest in, and you don’t have the information advantage that entrepreneurs enjoy in your business. herare dependent on market development without being able to actively intervene. Entrepreneurs actively manage their business, recognize opportunities, react flexibly and take risks. The opposite is true for the investor: He can only wait, hope and bet on long-term development. This misunderstanding – the misconception that risks are manageable – is one of the biggest cases in thearea of capital investment. It means that investors underestimate risks and suffer serious losses in an emergency.

Inflation risk: the hidden danger

Another, often underestimated risk factor is inflation. Many people believe that only hyperinflation like 1923 is dangerous. But normal inflation – which is an average of 1 to 3 percent in Germany – is the real danger. Because it gradually devalues the assets if it is exclusively in the current account or in life insurance policies that hardlyprotected against inflation. More than 70% of German financial assets are in such investments. The result: The fortune melts slowly but steadily without the investor noticing. The ill-considered hoarding of cash, which was reinforced in the course of the low interest rate phase, is not a sensible protection against inflation, but a dangerous strategy. over the yearsthe wealth loses value, which can significantly reduce the quality of life in old age. It is a creeping danger that many underestimate.

The Risk of the procrastinator: The eternal wait

Many investors react to the uncertainties in the markets with a kind of persistence. They say: “Now it is still too uncertain”, or “the prices are too volatile”, and keep postponing investments. The reasons are manifold: “The markets have run too high”, “the uncertainty is too great”, “I am waiting for better times”. But this attitude is an expensive trap.as a result, you never get back in on time in the event of price losses – for example during the corona crisis. Instead, one misses out on the recoveries and suffers enormous wealth losses in the long run. With inflation of 2.5% and an initial investment of one million euros, this means a loss of purchasing power of over 257,000 euros in 20 years. This is a creeping impairment thathardly noticed, but has a significant impact on the financial quality of life in the long term. The behavior of waiting is therefore one of the most expensive strategies to choose.

The Art of Risk Management

What can we learn from this? It is important to understand the risk realistically and to manage it correctly. It is not about completely avoiding short-term losses, but rather about protecting your own life plan and personal goals. Above all, risk means that you have to correct the standard of living downwards in the case of gross mistakes. Therefore, the following applies: Your ownRisk-taking should be well known and the investment should be aligned accordingly. This includes broad diversification, deliberate avoidance of systematic risks and an adequate liquidity reserve. If you observe these principles, you can remain calm and level-headed even in times of crisis and build long-term wealth. Because the real art isin keeping one’s own emotions under control and accepting the risk not as a threat, but as an integral part of the investment. This is the only way to find a balance between risk and return that corresponds to one’s own goals and individual resilience – for more security, quality of life and financial well-being in old age.