What is risk? In
the following definition from Webster’s Dictionary risk is defined
in terms of loss: “Exposure to the chance of injury or loss;
a hazard or dangerous chance.” But, a more appropriate definition
of risk for investors is “uncertainty of expected returns.” Most
investors think of risk as some sort of loss. To the surprise of many
investors, the potential for loss is also the reason they earn a return. “Loss
aversion” refers to the concept that the pain of losing a sum
of money is greater than the pleasure of gaining the same amount of
money. This is incorporated into the optimization process that uses
risk and return trade-offs of different asset classes to build portfolios.
Research shows that investors are about twice as sensitive to investment
losses as to gains.
Risk is most commonly measured in terms of standard deviation or the
volatility around a given average. Prior to the groundbreaking Fama/French
research, stock market risk was measured as volatility around the average
return of the total stock market. However, Fama and French added two
more dimensions to the measurement of investment risk — size and
price.
Investors envision risk in several different ways. One way would be the
worst case probability of a loss, such as the chance of not achieving
an expected rate of return, not being able to readily obtain an expected
amount of money at a specific time or the need to withdraw funds from
investments when they are in a cumulative negative return position.
Risk is one of the most avoided, least quantified and misunderstood subjects
by those working in the financial services industry. This is unfortunate
because the primary purpose of investment professionals is the intelligent
management of financial risks and the alignment of an investor’s
risk capacity with the appropriate exposure to financial risk or uncertainty.
One dimension of Risk Capacity™ is an investor’s knowledge
about risk, the more they understand it, the more capacity they have
for risk. We face risk because nobody can consistently predict the future.
After all, if we could see the future, there would be no risk. Wouldn’t
it be nice to get next year’s Wall Street Journal today!
Risk, return, and time are all interconnected. Higher exposure to the
right risk factors leads to higher expected returns. In accordance with
the law of numbers, the longer an investor holds a broadly diversified
risky investment, the more likely a long-term expected return will be
obtained. However, because of random drift, risk is very unpredictable
in the short run, yet more accurately quantifiable than gut feelings
and intuition in the long run. Random drift can be illustrated by flipping
a coin and obtaining 10 heads in a row. There is still a 50/50 chance
of heads the next time and every time in the future.
Risk and Return Correlate Closely
Investment risk and return correlate closely and are tightly intertwined.
The bottom line is that risk must be taken to achieve a return. Risk
is the currency of return. A greater return can be considered a payment
for investors subjecting themselves to greater uncertainty of those returns.
Without the uncertainty of gain or loss, why would there be any logical
reason for investors to earn money? This correlation is evident in virtually
all stock market historical data. There are ways to refine risk and return,
but at the end of the day, risk is the currency used to purchase returns.
With that clarification, the question then arises as to what denominations
and values can be identified. In other words, what are the risk factors,
and how are they priced? These questions were addressed by Eugene Fama
and Kenneth French.
Systematic and Unsystematic Risk
When Nobel laureate William Sharpe published his Capital Asset Pricing
Model (CAPM) in 1964, he decomposed a portfolio’s risk into systematic
or nonspecific risk and nonsystematic or specific risk.
Systematic risk refers to the risks of the entire market as opposed to
the risks specific to one stock. These market-wide risks are tied to
large scale risks like the risk of capitalism being a viable economic
social system. Other risks not specific to one stock include war, recession,
inflation, and government policies.
Nonsystematic risk refers to those risks that are specific to individual
companies. Examples include lawsuits, fraud, competition and other unique
circumstances related to a company. The important fact for investors
to understand is that there is no added expected return for nonsystematic
risk above the expected return for systematic risk. This is a very big
idea that essentially says that all stocks have an expected return that
is the same as the market or a market index fund return. However, those
stocks have more uncertainty of the expected return.
The incremental risk of one stock (nonsystematic risk) is unrewarded
risk, and therefore should be avoided by investors. However, the systematic
risk of capitalism is essentially the market risk and has earned an annualized
return of about 10% per year for 80 years. But, in periods of less than
10 years, the annualized returns can be very volatile and uncertain.
In periods longer than 20 years, the annualized returns of each period
are far more consistent than one to five-year periods.
Concentration Risk
Individual stocks and bonds contain both systematic and nonsystematic
risk. If investors hold the market portfolio of stocks like the Wilshire
5000, they have eliminated nonsystematic risk and they have not concentrated
their portfolio on fewer stocks than the market. Concentration risk occurs
when investors try to pick stocks and bonds that they think will outperform
the market. Concentration of investments is akin to speculation and add
risk, but provide no additional expected return.
Figure 8-10
Concentration risk
comes from all active management strategies such as stocks, timers, managers
or style picking. The opposite of concentration is diversification and
therefore diversification is often referred to as the antidote to uncertainty.
Figure 8-10 summarizes these concepts of riskese in a
flow diagram. Figures 8-11 and 8-12
explain the reasons to avoid concentration risk.
Index
Funds Reduce Uncertainty of Expected Returns
Portfolios of index funds shield investors from diversifiable risk
better than portfolios of active funds. Yet no portfolio, whether
active or index, can reduce the systematic risk or non-diversifiable
risk that is inherent in all portfolios. This is the market risk
that a person’s investments, however conservative,
will decline in value because of a market downturn.
8.2.7 The Dimensions of Stock Return
Researchers did not
have a very good idea about what sources of investment risk actually produced
higher returns until 1992. They previously only had Sharpe’s One-Factor
Model to explain how investment returns were derived as seen in Figure
8-13. However, Sharpe’s One-Factor Model explained only
about 70% of the returns of the stock market.
Figure 8-13
In 1992, Eugene F.
Fama of the University of Chicago and Kenneth R. French of Yale University
developed a three-factor model to characterize and describe the relationship
between risk and return for stocks. Their model is essentially an extension
of Sharpe’s One-Factor Model. Sharpe said that the amount of a portfolio
invested in stocks is the most important determinant of return. The Fama/French
model added two other fundamental determinants. Fama and French sought
to determine the factors that best describe why there are differences
among the returns of stock asset classes over long periods of time. They
first studied the period starting in 1964, the year that reliable computer
data was available. It was later updated and confirmed with data dating
back to 1926. In short, they tried to identify the factors that explained
the remaining 30% of returns left unexplained by Sharpe.
Fama and French concluded that exposure to three risk factors —
market, size, and price (book-to-market) — collectively do the
best job pinpointing the sources of investment risk that account for
stock market returns. Risk factors are sources of risk that the stock
market seems to reward over the long run. Based on the Fama/French findings,
these three risk factors constitute the dimensions of stock returns.
To review the average annual returns for the last 81 years, see Figure
8-14.
Figure 8-14
These three risk factors
combined explain up to 95% of the returns of the market in U.S. and foreign
stock markets. These findings suggest that an investor’s investment
performance in comparison to the stock market or other investors depends
almost entirely on the percentage of stocks (market factor) held in a
portfolio, and more specifically, the amount of small stocks (size factor)
and high book-to-market ratio stocks (value factor) held.
Figure
8-15
Figure 8-15
illustrates the three dimensions of market, size, and value in 20 different
index portfolios, as seen in Appendix A. Each colored circle represents
one index portfolio, with the red button representing the highest exposure
to market, small size stocks and value stocks.
Market Risk Factor
The first risk factor in the Fama/French Three-Factor Model is the amount
of exposure to the overall stock market or the market risk factor. Exposure
to this factor is determined by the amount of a portfolio that’s
invested in or exposed to stocks. The greater this exposure, the higher
the return in comparison to U.S. Treasury bills.
Size Risk Factor
The second risk factor in the Fama/French model is the amount of exposure
to small company stocks or the size risk factor. Exposure to this factor
is determined by the amount of a portfolio that is invested in small company
stocks. The greater this exposure, the higher the return in comparison
to large company stocks.
Small company stocks have small market capitalization. The market cap
is determined by multiplying the total number of shares times the price
per share. These stocks are generally perceived as riskier than large
company stocks because small companies have fewer financial resources
and more uncertain earnings than large companies. Small companies are
also less able to survive prolonged periods of economic downturns. Even
when small companies have good track records, these track records aren’t
very long, adding more uncertainty and greater risk to their stocks. Because
investing in small company stocks is riskier, investors demand a higher
rate of return.
It’s important to understand
that the average return of small-cap company stocks have significantly
outperformed large company stocks over the last 80 years by 3.13% per
year. But, to get higher returns, investors must accept a step up in
the uncertainty of those returns. Figure
8-16 plots the deciles (one-tenth buckets) of U.S. companies
sorted by size over the last 81 years. Note that a fairly clear line
exists between the less risky large-cap stocks in decile 1 and the very
risky microcap stocks in decile 10.
Figure 8-16
However, in shorter
time periods they don’t always outperform large company stocks.
In fact, the size risk factor fluctuates unpredictably. This is consistent
with the Random Walk Theory of changes in stock prices.
Price (Value) Risk Factor
The third risk factor in the Fama/French model is the amount of exposure
to low priced stocks, which is measured by a book-to-market (BtM) value
ratio. The book value of a company is just an accounting term for its
net worth, its assets minus its liabilities. The market value of a company
is its price per share times the number of shares outstanding. This risk
factor is known by several different designations. It has been referred
to as the value factor, BtM factor, style factor and price factor. Note
that charts referring to it may have any of these designations. The most
current designation is the price factor, referring to the low prices of
these stocks compared to a company’s book value or to other stocks.
Exposure to the price factor is determined by the amount of a portfolio
exposure to high BtM stocks. In other words, when a stock’s market
price is less than its book value, the BtM ratio is greater than one.
The greater the exposure to the price factor, the higher the historic
and expected return in comparison to low BtM stocks. High BtM companies
usually have low earnings and experience other signs of financial distress.
Investors don’t like these stocks for these reasons. As a result
of their poor track records, the market drives down the prices of these
stocks. This naturally makes them riskier to investors.
Stocks with a low BtM ratio have low book values relative to their market
prices and are termed growth stocks. Investors favor growth stocks because
they’re perceived to be great companies and therefore are less risky.
They represent successful companies with strong track records and healthy
earnings.
The Nobel Prize-winning contribution made by Merton Miller provides a
framework for better understanding the connection between the price risk
factor and stock returns. Miller set forth a simple but profound notion:
the cost of capital to a company equals the expected return to an investor
who holds its stock. A company’s cost of capital is equal to the
price or book value of its shares or the amount that a company must pay
in order to obtain capital from investors.The Figure below proves out Miller’s Nobel-prize winning research. The figure plots the 80-year risk and return characteristics for the entire U.S. stock market as divided by book-to-market ratios in 5 quintiles. As you can clearly see, the low-book-to-market companies (numbers 1 and 2) produced negligible returns that came with very low risk. The 20% of all U.S. companies with the highest book-to-market (number 5) were perceived to be in the greatest distress, and consequently paid a higher cost of capital (return) to their investors.
Figure 8-16a
For example, suppose that a value company and a growth company each approach
a bank for a loan. Which company will have to pay the higher cost of capital
(the higher interest rate) on its loan? The value company will pay the
higher cost because its future is less certain and the bank will need
to charge extra interest for taking the extra risk that the company won’t
be able to pay back its loan. Thus, the riskier the company’s stock,
the higher the cost of capital paid by a company.
Because the market perceives a value stock to be riskier, it drives down
their price so that the expected return is high enough to make it worthwhile
for investors to hold, despite the extra risk they take when buying
it. In this way, stock prices adjust, (the market sets the price at a
discount, so its expected return is higher) to reflect the perceived riskiness
of the stock. This ensures that the stock will be purchased, even though
growth companies have better earnings prospects and generally seem safer.
The key to understanding the connection between the price risk factor
and stock returns lies in focusing on the market price of a stock. A high
BtM ratio suggests that the market values the stock less than the stock’s
accountants. This is usually because the stock has poor earnings as well
as other indications of financial distress. This makes the stock riskier.
As a result, investors demand a higher rate of return to compensate them
for the risk that a high BtM stock will do worse than expected, go bankrupt,
and end up as one of the “stocks in a box.”
A 1987 study compared the investment performance of a portfolio of 29
growth stocks to one with 29 value stocks. The growth stocks represented
companies that were stronger and healthier than value stocks by every
economic measure, including return on total capital, return on equity,
and return on sales. The value stocks represented companies that had little
profitability, terrible management, and a bad image. Yet, the study found
that the value stocks outperformed the growth stocks, 298% to 182%, over
the five-year period of 1981 to 1985.
This means that investors earned higher returns by owning the stocks of
companies that did poorly. That seems counterintuitive to most investors,
since they tend to think that healthy stocks are better investments than
distressed stocks. After all, if investors ask for a stock tip, they want
to hear the name of the next Microsoft, not a stock with poor earnings.
The fact is that investors should be interested in great investments (value
stocks), not great companies (growth stocks).
Figure 8-17
Figure 8-17
illustrates the relationship between expected return and the three factors
of market, size, and value. Since we are only discussing stocks, the market
exposure is not shown on this plot. The higher the investment plots in
the top right quadrant, the higher the expected return. The full page
Figure 8-18 actually puts values of average expected
returns of various indexes over the market return. The blue circles on
the plot represent various indexes. The total market index is plotted
at the center of the cross hatch, which is a 0,0 on the scale of size
and value. The return in the top right corner is the highest return on
the plot. The dotted diagonal line represents indexes that would have
the same return as the market return. Also note that large growth stocks
have negative average returns relative to the total market return, with
the bottom left corner value being -4.71%. Large and safe companies have
lower risk associated with them and therefore have lower returns compared
to smaller companies. Note that a portfolio similar to Index Portfolio
90 (see Appendix A) plots with an expected average return of about 3%
over the total market return. Because Index Portfolio 90 has international
indexes in the mix, this is not entirely accurate, but it does give us an
idea of how this type of analysis works.
