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Risk and Reward Part I

By: Frank Armstrong

By: Frank Armstrong, CFP, AIF

Risk and reward may be related in the global sense, but they certainly don’t have to be in your portfolio!

It’s true – risk and reward are related. There are no high return investments that do not carry high risks. That’s certainly not new news. However, we can’t reverse the equation. We have all seen lots of high-risk strategies with disastrous results. Stated as clearly as possible high-risk strategies may not (and most often do not) produce high rewards. Investors lose sight of this at their peril.

Investors that fail to understand the relationship between risk and reward often shoot themselves directly in the foot, destroying their chance to reach their financial objectives.

It’s perfectly possible to construct an infinite number of portfolios with a 10% expected return. Some of them will have absurdly high risk. But, one of them will have the minimum risk necessary to generate that rate of return.

The relationship between risk and reward holds true only in a special case: Risk and reward are related only for securities in a fully diversified portfolio. As the investor moves from a diversified portfolio, he has no expectation of higher return, but he bears more risk. Since this additional risk earns no more return, it is uncompensated risk.

If we plot asset class returns against risk as measured by standard deviation, the appropriate relationship jumps out at us. For instance, we know that stocks have a higher past and expected return than treasury bills, but carry more risk. Small companies carry more risk than large, and yield higher total returns over time than larger companies. Investors demand that additional return for putting up with the additional risk. These additional rewards are called risk premiums, and spring from priced risk factors.

It’s no great mystery how this system works. The market’s self-regulating, self-adjusting, self-correcting price mechanism almost instantly adjusts prices of stocks to the point where future returns justify their risks. The Invisible Hand never sleeps as millions of investors examine securities around the clock with an eye to future returns and risk levels.

In an efficient market, no stock can be expected to have a higher return than any other with similar characteristics. If it did buyers would push the price up until the expected return was equal to other similar stocks. If most investors agreed that one small company stock had an expected return of 12%, while the other stocks of similar size and book-to-market ratio (BTM) had only an 11% expected return, the price of the first stock would almost instantly be pushed up to where it yielded 11% to the next purchaser.

If a company’s prospects suddenly improve, that improvement will quickly be reflected in its stock price, adjusting its future expected return to the market average.

Of course, individual stocks do have widely different returns. Because none of us can tell the future, there is an enormous amount of noise and uncertainty in the process. Some companies will do better than average, and some will crash. But, no one can know consistently in advance which ones that will be. So, unless you think you know better than a few hundred million of your closest friends who are looking at the same data, it’s delusional to think you can consistently pick winners.

In trying to “beat the market” investors pay a high price. Of course, we have transaction costs, and taxes. These must be subtracted from whatever return we generate. As a result, the highest probability is that rate of return will go down. But, by holding less than the full market portfolio, we pick up a boatload of uncompensated risk. That’s risk for which we can expect no additional return. True, the variation of returns is staggering. But in the net, the returns will not be (cannot be) higher. Lower return and higher risk is nobody’s definition of an optimum portfolio. We will define the optimum equity portfolio as the one equity portfolio that has the highest expected return per unit of risk.

The higher the concentration of holdings, the higher the uncompensated risk. At the far extreme we have an Enron only portfolio. On the other end we have the market portfolio. Both had the same estimated rate of return. But, one portfolio is still standing and growing, while the other vaporized.

Most investors define the market as being the S&P 500. But, the S&P is only one part of the optimum market portfolio. As it turns out, the optimum market portfolio is the global market. You would ideally like to hold your little pro rata share of every traded stock in the world. We can’t expect to get every traded stock in every exchange in the world. But, today’s index funds and ETF’s will capture in excess of 95% of the value of the world’s capital markets. The risk level for the S&P 500 is about 16% higher than the global market. International investing offers substantial risk reduction for long term investors. If your portfolio is only domestic companies, you are taking far more risk than you need to.

As a default portfolio, every investor should consider the global equity market portfolio. In fact, any investor that rejects the global equity market portfolio should have a very strong belief set to justify his/her position. Unfortunately, many investors have flawed belief sets, or none at all. So, it’s not unusual to hear variations of the following:

  • I work for Enron. It’s a great company. I know what’s going on there.
  • I can pick individual stocks that will beat the market.
  • The US is the only place to invest. The rest of the word is too risky.
  • Energy will outperform the rest of the market.
  • I’m a doctor. I understand health care stocks.

Not all of these people will crash and burn. A few very lucky ones will prosper. After all, somebody wins the lottery every week. But, the majority will pay a heavy price for failing to manage their risk properly.

That’s not quite the end of the story. As it turns out, subsequent research indicates that investors may wish to overweight small and value firms on a global basis to capture additional returns. Investors may correctly have different tastes for these additional risk factors, so the amount of overweight (if any) may be adjusted for individual preferences. See The Fama-French Three Factor Model for discussion of these additional risk dimensions.

Coming up:

Next we will look at how portfolios with high risk compound over time.