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8.2.6 Risk
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. |
