Risk

September 30, 2025

I’ve spent some time in past newsletters highlighting the work of economists and academics who developed the foundational principles of finance theory. Their work cemented the ideas surrounding risk and return, asset pricing models, and market efficiency. I want to spend a little time focusing on risk, hopefully in digestible terms.

It is now widely known there is a risk/return tradeoff in investing. Think of this dynamic, this tradeoff, like two sides of a coin, inseparable, and you can’t have one without the other. For me, this is like the gravity of finance. It is ever-present, portfolios are always under its influence, and countless folks have ignored this at their own peril.

Because the risk/return tradeoff seems so evident now, and even elementary, it is easy to say, “Yeah, I get it, risk and return,” and then carry on with investment decisions without really taking time to unpack the concept. We forget the deep dive the aforementioned people undertook to formalize and give structure to this.

In quantifying the risk/return tradeoff, Harry Markowitz developed the concept of the “efficient frontier”¹. This is my best summary: In the universe of risk and return, there exists an edge, a “frontier” where all efficient portfolios lie. Once there, if you want more return, you must accept more risk, and if you want less risk, you must give up some return. No free lunch. If you can get more return without adding any risk, your portfolio is not efficient—you’re not on the frontier yet—and it will be dominated by portfolios that are. Markowitz’s efficient frontier is the outcome of optimal portfolio diversification. The right combinations of assets, efficient ones, put you on the efficient frontier.

In finance, you are compensated by taking on risk. A key facet of the risk/return tradeoff is that you only get compensated by taking on non-diversifiable risk, because if a risk can be diversified away, you shouldn’t be compensated for it. Read that again. Non-diversifiable risk is “market” risk.

And often looked past is the nature of a “risk-free” asset. Ever really think about why it is called that? It’s called risk-free because it is essentially a guaranteed return. Short-term Treasury bills are a great example. Because they represent an obligation to you, and they have little to no default risk, they deliver a “risk-free” rate of return. Because of their risk-free nature, you are accepting a low return. The risk-free rate is a pure expression of the time value of money. If the risk-free rate is 3%, $100 today is equivalent to $103 a year from now.

You want more return, you say? Well, you are hoping to capture a “risk premium,” which is an extra layer of expected return on top of the risk-free rate. Notice I said expected, which may or may not be the return you realize—you are accepting risk after all. The size of this premium is related to how much risk you are willing to bear, the type of asset, etc. The price of higher returns is the volatility (risk) that comes with seeking them. Read that line again, please. Depending on the level of risk taken, the volatility experienced can be quite significant in the short term, and the longer you hold the asset, the more likely it is your realized returns will come closer to your expected return. This is basically the law of large numbers. The expectation for flipping a quarter is 50% heads, 50% tails. Over 4 flips, you might realize 75% heads and 25% tails; 10 flips, 60% heads and 40% tails; 100 flips, 51% heads and 49% tails; and so on.

You don’t like that volatility, you say? Well, you better turn around and head back toward the risk-free rate. As your hilly road (volatility) smooths out, you will be at lower elevations (return). Somewhere between Mt. Everest and Florida you will find a comfortable balance.

Dan Cunningham, our founder, touched on a risk-related topic in his most recent newsletter. If you know Dan, you might have detected an edge, some frustration even. He was speaking to the rise of all kinds of ETFs that no longer track broad market indexes, use leverage, take short positions, and slice and dice the market into all kinds of niche holdings. This kind of thing usually happens when it’s late in the party, and people have forgotten about the hangover. Like when your maniac friend wanted to do shots at 1am. “What’s one more?” he says. We’ve all been there.

John Bogle, the founder of Vanguard and creator of the Vanguard S&P 500 index mutual fund, foresaw this ETF madness. He warned there would be a day that ETFs would morph into a myriad of things far from their original purpose of simply tracking broad market indexes. He knew the industry, long since capitulating to index investment, would find a way to prey on people’s instincts to trade, to gamble. Since the stock-picking high has waned, like a dealer showing up with a new drug, the industry thought the next best thing was to create narrower, complex, and all kinds of “flavors” of ETFs for the average Joe to get excited about trading. These are not the broad market index ETFs that we use in our investment plan, but ones that were no doubt created to incentivize more and more trading. At first glance, trading these “niche” ETFs seems less risky than individual stocks, but now, in some cases, it is arguably worse. Your triple-levered ETF, inverse tech sector ETF, or derivative-based “income” generating ETF, might get you a short-term high, but this hangover will be no joke. The late Waylon Jennings, one of the greatest country singers of all time, said it best in his song “I’ve Always Been Crazy.” This perfect lyric applies to so many things in life, especially investments.

“Are you really sure, you really want what you see

Be careful of something that’s just what you want it to be”

As humans, we are easily influenced to make decisions that don’t necessarily align with our own best interest, and in the world of finance, there are many actors facilitating our worst instincts. When the markets are rocketing, it is quite easy to forget the foundational tenets of risk and return and pile into a bunch of investment products with little regard for their risk, but in our punch-drunk state, gravity is still lurking.

In my previous career, we spent a lot of time training on “low frequency, very high-risk” events. The idea is that even though their likelihood of happening is exceedingly low, when they do, rarely do you get a do-over. As in you are no longer around to learn any lessons. If the bulk of your portfolio is in one stock or in niche, highly leveraged, or flavor-of-the-month investments, you are in a no-recovery territory when the party comes down from its high.

Remember that no matter how we try to escape the gravity of finance, it will always remind us it is there, usually right about when we’ve forgotten about it. And the reminder is far worse for those who never bothered to learn the inescapable principles of risk and return.

- John Bass

1. Markowitz, H. (1952). Portfolio Selection. The Journal of Finance Vol 7, No.1 (Mar 1952), pp. 77-91