Risk Rewarded?

All things being equal, investors should expect a positive correlation between risk and return. After all, if risk is not generally rewarded, there is no incentive to take that risk. Theoretically, there should be a linear relationship between risk and return as illustrated by the chart on this page.

2011 was a year that many investors, both amateur and professional, would prefer to forget. After good rates of recovery for many types of investment in in the previous two years, 2011 represented a backward step. This stemmed from the problems crystallising within the Eurozone and the procrastination of politicians in dealing with these problems which created a great deal of distress in financial markets.

The fear in financial markets, which became most contagious during August and September, was based on the perceived increase in probability that Greece would be allowed to default on its debt in a disorderly manner. This would have created a scenario whereby in all likelihood, a number of major European banks would have failed.

It should always be remembered that when an individual or entity defaults on a loan, it is the creditor who loses money. Unfortunately, the main creditors to Greece are European banks, the largest of which is a German bank, Commerzbank. Furthermore, such is the interconnectivity of the global banking system that many other banks around the world would have lost money and perhaps have been fatally weakened. There was also a real danger that the sovereign debt crisis would have spread to other Eurozone countries.

Investors, therefore, became extremely cautious and this caused money to flood into low risk assets such as UK gilts even when they were already providing historically low yields. Safety was certainly in fashion.

If we look at how the main investment asset classes behaved during 2011 it is evident that risk was not rewarded.

The horizontal axis represents risk (pictured above) as expressed through capital volatility whilst the vertical axis represents the return achieved during the timeframe. The chart shows that the trend line is from top left to bottom right. In other words, there was an inverse relationship between return and risk. Looking forward, I believe that there is every prospect of the risk/reward relationship returning to its expected long-term trend during 2012, although there are certain to be a few wobbles along the way.

Finally, a strategy has been found that (in the medium term) reduces the risk of default in the Eurozone. The European Central Bank (ECB) is empowered to provide unlimited three-year loans to European banks at exceptionally low interest rates. There has been a voracious appetite for this money, which has had the effect of injecting up to €1 trillion into the European banking system.

Not only does this arrangement increase the capacity of banks to survive a sovereign default it also serves to reduce the risk of default in the first place. This is because much of the money borrowed is used to purchase new sovereign debt, which helps to keep interest yields at a sustainable level.

In effect, this arrangement is very similar in outcome to the quantitative easing in the UK and United States.

Particular beneficiaries of this have been Italy and Spain, where the rise in Government bond yields (10-year duration) has been arrested at around the rate of five per cent per annum. Compare this with Greek debt, where 10-year yields are currently over 30 per cent per annum.

The only negative point for investors is that the amount of money that has and continues to be poured into sovereign debt markets by the central banks could be creating a bubble in fixed interest markets. If the flow stops at a time when interest rates and inflation are rising, there is plenty of scope for values to fall. This is another reason why investors need to pursue a diversified strategy.