Understanding Uncertainty, Risk and Returns

Dr. Ajibola Awolowo

Mrs. A did extensive research, bought some shares in a top Nigerian bank at N50 per share. The bank however missed their projected earnings estimate and the share price dropped to N35 per share 3 months after she had invested. She lost 30% of her capital.

Mrs. B heard about a new ‘investment company’ in town from her hair-dresser. The firm pays 20% return on investment every month till you decide to liquidate your ‘investment’. She proceeded to put in N100,000 which was her entire savings. 3 months later, she liquidated her investment having made N60,000 profit on her capital and earning a return of 60% in the process.

The question before us today is which of these 2 women took a greater risk with their capital? I hope at the end of this article, we should know enough to unanimously reach a consensus answer.

Unfortunately, risk is a concept that is poorly understood by individual investors and often time, not considered when they take investment decisions. It is however so important that it can make or break.

Banks, who are the experts in all money matters, have a Risk management department that considers every loan application to determine the level of risk it carries and decide if it is worth undertaking or not.

Risk is simply the probability that things may turn out differently than one may have initially planned. We make investment decisions in the hope of making a profit. This is our plan. Risk however dictates that things may not turn out the way we anticipate. Risk is the possibility of permanently losing your capital.

According to Professor Elroy Dimson, “Risk means that more things can happen than will happen”. The fact that you made money from an investment does not mean it was less risky than one you lost money on. Risk therefore goes hand in glove with uncertainty. The more uncertain a situation is, the riskier that situation is.

Some investments are traditionally called risk-free investments because they have a high level of certainty. An example of this is a bond issued by the government of a country. It is unlikely that the government will not be able to pay the coupons on the bond or redeem the bond at maturity. The exception to this was demonstrated by Argentina, Russia and Lebanon that defaulted on their sovereign debt in recent times.

This denotes high certainty of payment which translates to low risk. The more stable the country issuing the bond is, the more certain they will honour the bond and the lower risk the bond carries. This is why a bond issued by the United State of America carries a lower risk that that issued by the government of Nigeria.

When considering corporate bonds, some companies are large, respected, have a good track record, integrity and have more to lose if they default. Their bonds, therefore, will have a greater certainty of payment and lower risk than a new company with no track record.

If the corporate organisation fails and is being liquidated, bond holders are considered first before equity holders are paid off. In light of this, corporate bonds carry a greater certainty and lower risk as compared with buying shares in the same corporate entity.

When buying shares in any company, there are lots of factors that may introduce uncertainty or risk into their operations. These factors can be found in the annual report of every company but unfortunately, most individual investors are only concerned with the profit and dividends declared.

Every company and industry have peculiar risks they face. A quick look into Dangote Cement PLC annual report for 2020 highlights some risks that they face going into the New Year. This includes threat to staff well-being by the COVID pandemic, export restriction at land borders, funding delay by lack of foreign exchange, disruption of supply chain, fatal accidents involving their trucks, loss of market share in the countries where they operate, inability to repatriate funds from various countries, political instability amongst other things.

How many individual investors are aware of these factors, their possible impact on company performance, think about ways through which the company mitigates these risks and use all this information to make investment decisions?

All this adds up to why equity investing involves a lot of uncertainty and higher risk as compared to bonds.

To take this further, think about venture capitalists and angle investors. They invest in start-ups that do not have any financial record, no track record of performance and are often crippled by debt or losses. Most times, all they have is a novel idea and an enthusiastic founder. It is very uncertain if the business will thrive or die. Classical high uncertainty leading to high risk assets.

So far, we have considered 2 factors –Uncertainty and Risk. The third factor I would like to introduce is “Returns”. Returns are the rewards one gets for investing their money. This can be in the form of interest, coupons, dividends, rents or capital appreciation.

These three factors must always be considered together – Uncertainty, Risk and Returns.

The common and popular concept is that with high risk comes high returns. Taking this at face value can be, however, misleading. Difficult and specialist jobs often command a higher pay. In the same way, putting your money in ventures that have a high risk and only a few people are willing to commit to should ideally be rewarded with greater returns.

Unfortunately, this view neglects the third concept we discussed which is uncertainty. Investments with low uncertainty are accompanied by low risk. This means that the possibility of outcomes that differ from your plan happening is low but not non-existent. The market therefore rewards this with a low return. Hence, bonds issued by the United State of America have very low returns.

With higher degrees of uncertainty comes higher risk. The probability of the outcome being different from your initial plan is very high. You therefore have a greater chance of losing your capital in high uncertainty, high risk investments. This great possibility of loss should be seen side by side with the promised high returns. This should be strongly considered prior to investing in such ventures.

Now that we understand the relationship between uncertainty, risk and returns, we can see why being able to evaluate risk is a key step in deciding which investment opportunity one should pursue. The next logical question would be, how can we objectively measure risk? If we are able to ascribe a definite value for risk, we can compare this across various opportunities within the same asset class to decide on which one to undertake.

Unfortunately, the author of the timeless book “The most important thing”, Howard Marks, opines and I agree, that risk is difficult to exactly quantify before an investment and even after the outcome of an investment is known.

The best we can do as individual investors is to evaluate asset classes separately and consider all our options within each class. Since equity investing is our focus, I always advice understanding the company and its industry. Doing this will entail reading their annual report thoroughly to get an idea about the risks the company faces and what the company management is doing about those risks.

Determining the risk levels of any investment will also differ from individual to individual. An investment that may be too risky for me, as losing my capital in that deal would be disastrous for me, might just be acceptable to you if you have a larger capital base that will not be dented by this present loss.

When the cost of you losing your capital in an investment exceeds the possible benefits or gains that can be made, such an investment should be considered too risky and passed on without second thoughts.

Risk is not determined by the outcome of an action. Risk is determined by the thought process and all the considerations that went into producing the outcome.

Adequate risk management may still end up producing occasional negative outcomes as banks, despite all their risk management, still have bad loans. Adequate risk management will, however, minimise the impact and probability of having negative outcomes while maximizing your positive outcomes.

This brings us back to our original question at the beginning of the article. Who do you think took on a greater level of risk, Mrs A or Mrs B?