How can an investor set about trying to balance risk and return? There is no universally accepted formula or simple rule for this. Instead, each investor needs to consider his or her unique financial situation. First, determine as best you can your present financial assets and liabilities. It is important to recognize that even at this stage—before looking to the future—there can be significant uncertainties about how to value your assets and liabilities.

What Is Alpha, and Would You Like Some?

Some investment professionals describe their work as a search for positive alpha. Alpha is defined as the difference between an investment’s actual expected return and the expected return that modern portfolio theory says it should have. Investments with positive alpha are said to be underpriced. Investments with negative alpha are said to be overpriced. Unfortunately, the search for alpha is complicated by three sources of noise that can lead the unwary astray: luck, hidden risk, and fraud. A manager who is lucky may appear to be a good source of alpha, but outperformance that arises from luck is likely to be fleeting. Worse are the instances where managers generate outperformance by (consciously or unconsciously) making risky bets that are likely to work for a while, until they fail dramatically. Short-term incentives at banks and hedge funds led to a dramatic increase in levels of hidden risk and are likely responsible for the financial crisis of the last few years. Finally, there are still too many bad actors in the investment business who try to get away with anything they can, and whose recent crimes are likely to keep the courts busy for years to come

Fortunately, finding real positive alpha, based on skill rather than luck, hidden risk, or fraud, though it may be rewarding for professionals who are judged against their peers, is neither necessary nor sufficient for most investors. Indeed, identifying small mispricings may be more effort than it is worth, especially after transaction costs are taken into account. What’s more, it can distract from the important task of estimating and planning for future liabilities.

In some cases, a range of values gives a more accurate depiction of reality than does a single number, which offers only the illusion of precision. For example, an inactively traded stock is hard to price accurately; its value is only an educated guess. In such cases, it may be prudent to set its value to a small fraction of what analysis says it should be worth. Sometimes, however, this approach can be costly. Biasing your estimates of value can distort the overall picture of your portfolio and lead to bad investment decisions. On the liability side, a mortgage that can be refinanced is not a simple investment: Its current value depends on future changes in interest rates and the availability of credit.

Shifting our focus from the present to the future, we are confronted with an exponential increase in possibilities. This complexity arises from the need for and interaction of three financial forecasts:

• Future personal earnings

• Future performance of investments

• Future liabilities

Let’s face it, even the most rigorous analysis of investment alternatives cannot guarantee a good result in the face of so much uncertainty. Why? Because of the uncertain relationship between future earnings, investments, and liabilities that each investor must try to understand. Risk is the dark side of opportunity. It is often said that there is no opportunity without risk. Even so, some opportunities are better than others. Some risks are more worth bearing than others.

An important consequence of the relativity of risk explained in the previous chapter is that performance standards do not attempt to compare unrelated investments by adjusting for risk. Instead, the standards limit themselves to comparing similar investments with each other, trying to ensure that comparisons are relevant, meaningful, and fair. Organizations that have created performance standards, such as the CFA Institute, tend to focus on the return component of performance.

This leaves investors with some difficult tasks—estimating their likely future assets and liabilities, developing a reasonable set of financial objectives, and trying to identify and avoid the risks that matter most to them. Good financial planners can help; unfortunately, all too many planners are narrowly trained in a particular product area. Furthermore, most planners do not have the proper degree of detachment from the products they are hired to evaluate. Finally, many lack an understanding of the risk/ return relationship. Fortunately, the increased sophistication and information access of individual investors is likely to force financial planners to better serve their clients.