“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 more than 155% during the preceding five years.
At the same time, the U.S. Housing Market is on fire, up more than 77% in the past five 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).
More than 16 years later, what has transpired?
1) Volatility in both Gold Miners ($GDX) and U.S. Home Construction ($ITB) was significantly higher than that of the S&P 500 ($SPY).
2) The maximum drawdowns of more than 80% for both the Gold Miners ($GDX) and U.S. Home Construction ($ITB) far exceeded that of the S&P 500 ($SPY) at 55%.
By all accounts, investors in Gold Miners ($GDX) and U.S. Home Construction ($ITB) incurred a much higher risk than did 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 U.S. Home Construction ($ITB) and a negative return for Gold Miners ($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 the markets. You are owed nothing by simply buying a security — 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’ve 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 U.S. Housing Construction seemed great in May 2006, but that’s always the case after a strong run in performance. 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.