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.
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.
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.
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.
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 illustrate the reasons to avoid concentration risk.
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