In finance, we often see that high return instruments should be accompanied by high risk. Is it possible to have a high return and a low risk financial instrument?
One situation where this is possible is when you purchase an asset well below market value. If you have deep knowledge of a niche area and are willing to invest time searching for value, this isn't that hard, but it requires effort.
I've done this for years in vinyl records and other collectibles.
In general no, due to how the market works.
When you invest you are loaning money to someone to wants it (to start a business, for example) in exchange for a return.
If some investment is safe, then it will attract lots of people, so there will be lots of sellers (of money) and the buyers (the people taking the money) can pick whoever they want (the ones who ask less in return). This drives the profits of the loaners (the price of the loan) down.
And of course, low and high are relative. If due to some change (for example a technological breakthrough) returns would increase all of the economy, the safer options would still give a lower return than the more risky ones.
The only exception would involve expert knowledge and lots of luck: you know something very few in the public know. Let's say that you hear about a new invention and you realize that this will revolution the way the cronopy industry works, that everybody in the world building cronopies will want it and that it is a sure sell, and that for whatever the reason nobody else in the industry has heard about the invention1 so very few people know how valuable it is and there are no other investors interested.
As you can guess, this is not something that happens often. And many times, this is the beginning line of a scam...
1If the inventor made the device with the idea of selling it to the cronopy industry then probably he has already informed the people of that industry in order to get financing, but maybe the inventor has not realized the possibilities of his invention in that industry...
I would actually say that YES, low risk and high return is possible, given good diversification in a stock portfolio and most importantly, long enough time horizon.
One measure of risk is volatility, but in the very long run it doesn't matter. I would say that in the very long run, analyzing risk is better done with worst-case scenarios. The reason is that stock prices are not just some abstract process doing random walk, but rather there is a tendency to revert to the mean.
In the very long run, the returns of your stock portfolio come almost exclusively from dividends and their reinvestment creating even more dividends. The valuation of stocks for let's say 50 years from now is not a deciding factor.
If you purchase a small share of Corporate America (or Corporate Whatever-Country), by buying a well-diversified low-cost index fund, you own a certain fraction of the economy of such a country. I can't see how the investment would go wrong unless there's a major disaster like a thermonuclear war or climate change gone out of control. In the long run, you own a certain fraction of the profits created by Corporate America.
Example: 3% dividend yield, 5% growth+inflation will yield nominally 46.9x = 8% per year in 50 years. If the valuation of the stock market halves at the worst moment (i.e. at the end of the investment period, so that you won't have good reinvestment opportunities for dividends), you still have 23.5x = 6.5% per year. And that's a poor scenario unlikely to happen! By slowly exiting the stock market near the end of the investment period instead of quickly exiting the market, you can manage the risk of market halving at the cost of some lost return.
If you are risk averse and invest in bonds, you gain only 3-4% per year. Note the nearly-worst-case stock scenario is still better than average-case bond scenario.
An absolutely horrible scenario: stocks drop by 80% exactly at the end of your investment period (happened in the Great Depression). You gain 9.38x = 4.58% yield in 50 years. This very unlikely scenario still yields more than bonds.
So, based on these, in a 50 year time horizon, stocks yield more than bonds even in the worst case.
How could a stock portfolio investment go wrong?
- You don't diversify well enough and the stocks you picked underperform compared to the market.
- You have high fees.
- You often temporarily exit the market thinking that the situation is too risky, and the situation becomes less risky (i.e. stocks become more expensive). Don't time the market! Instead, spend time in the market.
- You invest not for 50 years but rather for 5 years.
Well, write covered-calls on commodities but then hedge the commodity with a futures contract. Some years might be a 10% or more gain while other years will be less. So call that a 5% average.
Why does this work ? The use of capital can hold both the commodity and hold the hedge. The buyer of the option is putting forward less use of capital and that's what they like.
Commodities ? Commodities that the average person can hold are stock indexes, Treasury securities, and precious metals. Most other commodities on the stock market are in the form of short-term futures but even those holdings can have covered-calls written on them when they are large ETF's.
The futures hedge ? The hedge can be a long-term sell-side futures contract when the market is in contango but should be a series of short-term contracts when the market is not in contango. The issue is the cost of hedging.
There is one thing for an option-writer to know and that is the competition is other option-writers. The customers are the option buyers.
Or somewhat similar, closed-end-funds that invest in bonds, both leverage the bonds and hedge the bonds. So consider letting a financial company do the work.
Obviously, there are un-hedged investments that will outperform a 5% average when over long periods of time. A hedged investment is more like a regular business practice that is depended-on rather than a long-term investment that is hoped-for.
Oh, there is another situation. When a company appears headed for financial trouble, investors interested in the company will buy the senior bonds and short-sell the stock. The bonds pay dividends which cover the cost of short-selling and the short stock position can go up more than the bonds go down. The bonds have a limited downside because the senior debt holders become the new shareholders in a re-organization.