“Higher risk, higher reward.”
This is one of the most repeated maxims in investing, and the basis of Modern Portfolio Theory.
It’s also intuitive: riskier investments should be compensated with a higher return.
But what should happen and what actually happens is not always one in the same…
It’s May 2006 and Gold is all the rage, having advanced over 155% during the preceding five years.
At the same time, the US Housing Market is on fire, up over 77% in the past 5 years.
Naturally, investors are extremely bullish on Gold/Housing, and looking for ways to make a more levered bet.
And so, two new ETFs are born to meet this demand: Gold Miners ($GDX) and U.S. Home Construction ($ITB).
Over 16 years later, what has transpired?
1) Volatility in both the miners ($GDX) and home construction ($ITB) was significantly higher than the S&P 500 ($SPY).
2) The maximum drawdowns of over 80% for both the miners and home construction far exceeded that of the S&P 500 (55%).
By all accounts, investors in miners ($GDX) and home construction ($ITB) incurred a much higher risk than investors in the S&P 500 ($SPY). Did that translate into a higher reward?
The S&P 500 ($SPY) has returned 9.4% annualized versus 3.4% for home construction ($ITB) and a negative return for the gold miners ($GDX).
Higher risk, lower reward…
This story is an important one for investors for a few reasons.
First, it serves as a reminder that there are no guarantees in markets. You are owed nothing by simply buying a security and certainly not any minimum level of return.
Second, while no big reward comes without risk, that does not mean that all big risks are rewarded. To the contrary, the riskiest individual stocks are the ones that go to zero (Lehman Brothers, Enron, WorldCom, etc.). And as we have seen here, high risk industries can underperform for long periods of time.
Lastly, it drives home the importance of diversifying, because we just don’t know what the future will bring. The prospects for Gold Miners and Housing seemed great in May 2006, but that is always the case after a strong run. Diversification is the best protection against the possibility that the future may look different than the recent past. And it’s also the best way to maximize the odds that the risks you take will actually be rewarded.
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Disclaimer: All information provided is for educational purposes only and does not constitute investment, legal or tax advice, or an offer to buy or sell any security. For our full disclosures, click here.