The Inextricable Link Between Risk and Return

Most frauds are based on a false premise about the world. Fraudsters tell a story about this false premise to extract value from their victims. The story driving two recent fraud cases claimed that you can have high investment returns with little or no risk. Mike Hallam was promised annual returns ranging from 12% to as much as 49% that were “safer than government bonds.” Richard Whitacre was promised “guaranteed” annual returns of 10.5%, 15% and up. Both gentlemen lost nearly all of their retirement savings to alleged Ponzi schemes. 

Financial history shows us why these promises are too good to be true. Let’s start with perhaps the safest investment in the world - three-month U.S. Treasury bills. From 1926 to 2024, three-month T-bills generated annual returns ranging from a low of approximately 0% to a high of 14%. The annualized return (geometric mean) over this 99 year period was 3.31%. T-bills have not lost money over any calendar year since 1926. Returns were zero in some years, but never negative. Thus, the risk of losing money is zero. 

Let's now consider the stocks of small U.S. companies, which are on the high-risk end of the spectrum. Stocks are generally riskier than bonds, and small companies are generally riskier than larger companies because they are more susceptible to market fluctuations and competition, they have limited access to capital, and they may struggle to attract and retain skilled employees. The annualized return for small U.S. stocks was 11.5% between 1926 and 2024, nearly 3.5 times the return of T-bills. However, small U.S. stocks lost money in 35 of those 99 years, sometimes quite a bit of money. In 1937, small U.S. stocks lost nearly 60% of their value! 

The data below is the annualized return of five different U.S. asset classes and their probability of losing money in any calendar year over the 1926-2024 period:

Three-month Treasury Bills:

Annualized return:  3.3%
Probability of loss:  0%




Five-year Treasury Notes: 

Annualized return:  4.9%
Probability of loss:  12%






 




Twenty-year Treasury Bonds: 

Annualized return:  5.1%
Probability of loss:  26%






 




S&P 500 Stocks: 

Annualized return:  10.5%
Probability of loss:  26%




Small U.S. Stocks: 

Annualized return: 11.5% 
Probability of loss:  35%




 

We can use this data to build a simple model of risk and return. Imagine a graph with the probability of loss on the horizontal x-axis and the annualized return on the vertical y-axis. Now imagine plotting the data for each asset class on the graph. The points would rise from the lower left quadrant (low risk, low return) to the upper right quadrant (high risk, high return). This rising curve illustrates the fundamental trade-off between risk and return. 

It should be clear from this simple model that high investment returns cannot be earned without taking substantial risk. Safe investments, by their very nature, produce low returns. These are the true facts about the world. To believe otherwise is to completely disregard financial history. 

The tragic losses of Mike and Richard underscore the vital importance of financial literacy. By understanding the fundamental trade-off between risk and return, we can protect ourselves from promises that are simply too good to be true. 

What models or rules do you use to protect yourself from these types of scams?

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