The Ideas Column: Risk worth taking?

The basic principle of all financial theory is deeply embedded in the investor psyche: more risk means more reward. It makes perfect sense - why would someone take bigger risks if they did not expect bigger rewards?

The unthinking acceptance of the principle pushes long-term investors into equities by default, perhaps with a cushion of bonds to protect against the bad times when risks are realised.

Unfortunately, the principle turns out to be questionable, at best.

Consider the UK equity market. The FTSE 100 hit a new high in February, passing its 1999 peak. This should have vindicated buyers of equities, particularly since, when dividends were reinvested, shareholders made 70 per cent even if they had bought at the height of the dotcom bubble.

Over 25 years, UK blue chips have compounded at a rate of 8.6 per cent a year - a wonderful investment for those who stuck with shares through the booms and busts of 2000 and 2007.

Yet those who bought boring bonds made more money over that period. The annualised return from always holding the latest 10-year gilt and reinvesting coupons was 8.9 per cent. Unlike shareholders, bondholders would not have been tempted to dump their holdings when things looked awful during crashes - and could have bought in at almost any time and made decent money over a decade, unlike in shares.

Even within the stock market the idea of higher rewards for higher risks has not worked. The success of Warren Buffett and the entire leveraged buyout industry is based mainly on low-risk shares beating higher-risk shares for decades. Add gearing to one of these relatively safe holdings and history suggests you will retire rather richer than you otherwise might.

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This is clearest in some strategies using options. By selling put options, investors can take a steady income in return for heavy losses when prices fall. Just like Buffett, investors can act as an insurer: covering others against losses in falling markets. Sometimes this is very lucrative, acting as the equivalent of the insurer's premium income, which is very high when investors are scared. At other times it is not lucrative at all, because investors are unwilling to pay much for protection.

Over time insurers make money, and so it has been for selling puts. Since 1990 the CBOE PutWrite index has beaten the S&P 500 handily and been less volatile. Investors will pay up for peace of mind.

< > The easiest proxy for how much Mr Market is willing to pay the seller of puts is the Vix index for America's S&P 500 index, or equivalent measures of "implied volatility" elsewhere. When the Vix is high, sellers of puts are paid a lot for the insurance they offer; broadly speaking, others see risk as high. When the Vix is low, the premium is paltry: Mr Market sees few risks out there, so will not pay much for insurance. This helps explain why put writing has underperformed shares during the equity rally of the past three years.

Thinking like an insurer would have investors do the opposite to the market, taking on more risk when premiums are high and less when they are low. This is the key to understanding why higher-risk assets are not necessarily higher-reward assets: one has to consider the equivalent of the premium on offer, whichever market one is in.

At the moment, nominal yields on bonds are terrible, and the yield on most inflation-linked gilts is heavily negative. When it comes to shares, valuations are high, or very high, in many markets as investors seek alternatives to expensive bonds. High valuations imply future returns on shares will be lower than normal.

Finally, the reward for providing insurance on shares is not particularly attractive, although the Vix is well above its lows of last summer. Rather than be sellers of insurance, perhaps shareholders should consider being buyers, protecting their portfolios against losses.

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