Risk and Reward

Hear the echoes and
Feel yourself starting to turn
Don't know why you should feel
That there's something to learn
It's just a game that you play
--Al Stewart

'Common wisdom' in mainstream financial advice is that stocks, while being riskier than other asset classes such as bonds, handily outperform over time. Thus, investors should buy and hold equities for the long term because the longer one holds stocks, the more likely they are to outperform bonds.

Anyone who understands the relationship between risk and reward should see problems with this thought process. Axiomatically, riskier asset classes present prospects of higher reward. After all, who in their right mind would invest in a high risk, low reward proposition? But risky investments also carry higher potential for loss. If they did not, then by definition these asset classes would be low risk and high reward and everyone would pile into them, driving prices higher and reducing reward (which would bring the risk:reward relationship back in line).

Of course, proposing stocks as low risk and high reward in the long run is likely to draw doubts from even gullible clients.

A more truthful statement is that risky asset classes like stocks have potential for high returns over time but also potential for high losses over that same time horizon. In other words, investors heavily into stocks should prepare themselves for the prospect that their portfolios could just as easily be down big after 30 years as they might be up big.

If that were not the case, then the risk:reward axiom would be wrong.