By: Frank Armstrong
*As seen on Forbes
Even though investing is a multi-dimensional process, the first step in building your portfolio is understanding what drives investment returns. Fortunately we have so much data that sifting through it yields a treasure trove of insight into how the market works to reward investors for taking risk.
Investors demand a premium for parting with their money. On an asset class level that premium is fairly well related to the risk of the asset class.
For an investor unwilling to take risk, the real return is zero. While the nominal return from bank deposits, Treasury Bills or Money Market funds may be positive, it so closely tracks inflation that it’s almost indistinguishable from zero. So while we might be getting a two percent nominal returns, if inflation is two percent, the real return is zero. We won’t be able to buy any more goods and services tomorrow than we could today. That’s not much compensation for delaying gratification.
Because we are taxed on nominal interest returns, on an after tax basis those zero returns are often negative. Taxable investors might be better off hiding the money under their mattresses. Of course, hiding their money under the mattress subjects them to potential theft risk. But, I digress.
We generally use the US Treasury Bill as the definition of zero risk because the chance for default is so very small, and the time period to maturity is so short.
Zero risk assets make us feel good. We know at every point in time almost precisely what they will be worth, and there is no chance of loss. Zero risk assets are virtually guaranteed not to grow. But, that doesn’t mean that they can’t have an important part in your portfolio, or that for some uses they are the only appropriate holding.
As we depart our zero risk, safe haven, feel good investments we must accept some level of variability in the returns. You no longer know for sure what your holdings will be worth tomorrow or next year, or even ten years from now. Variability of returns is a very good definition of risk.
We know that most people hate risk. They much prefer a known result. They hate the idea of potential loss at least twice as much as they enjoy the idea of a potential gain.
To pry investors away from their zero risk assets they must be offered the possibility of a higher return than the no risk asset. We know that risk and reward are related. Bill Sharpe won a Nobel Prize in economics for his work quantifying the relationship between variability of returns and expected returns. But while Sharpe postulated that investors were only concerned about variability relative to the market, it turns out that investors factor some additional risk factors into the equation.
For each risk factor investors demand a premium of additional expected return. By looking back at a few billion data points over a long period of time, today’s computers can tease out what those premiums are. For instance, if long term returns in 30 day treasury bills are 3%, and the broad US equity market delivered an 11% return, then the premium demanded by investors for taking that market risk was 8%.
It turns out that premiums are reasonably stable over long periods of time. Of course, you know that past returns are not a guarantee of future returns, but knowing the past premiums is the first step in building a portfolio to meet your needs.
The flip side of the picture is that these premium demands by investors set the price of assets in an open market. Investors make their best guess at future earnings of an asset and discount the price of it until they get their desired expected return for the asset. Of course, depending on how optimistic or pessimistic investors feel at any given time, their discount factor can change at a moment’s notice. And new information is processed more or less instantly that impacts their judgment of future earnings. So, prices go up and down in unpredictable ways as a few billion of your very closest friends make their predictions of future scenarios. The price of an asset class at any point in time is determined by the sum total of all their predictions.
While the price movements are unpredictable at any given time, by looking backwards at an asset class behavior, they can be quantified within broad limits. Economists use Standard Deviation of the returns to measure the risk of an asset class. This yields a hazy understanding of how much they might vary over time. So, we can guestimate how much prices might vary in any particular average time period, and how often extreme events might occur.
Finally we know that the longer an asset class is held, the closer the returns get to the expected return. That is to say the difference between the worst case and best case narrows over time. But, you could hold an asset class forever and the return variation will never get to zero. There is always going to be some uncertainty of return. Risk isn’t going away.
Acceptance of some risks are compensated in very systematic ways. Not surprisingly, these risks are referred to as compensated risks. Compensated risks generate return premiums. Other risks are not compensated. The rational investor avoids any risk that isn’t compensated. More about that later.
As a first step in designing your portfolio, I’ll be following up over the next few articles with a discussion of the various compensated risks that drive returns in both stocks and bonds. Down the road we will discuss how to mitigate those risks and construct a portfolio with the highest probability of meeting your goals within your risk tolerance.