Step 8: Riskese

Understand how risk, return and time are related

8.2.6

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.

Figure 8-10

Diversification versus Concentrated 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.

Members of the Dimensional team talk about the advantages of diversification.

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.

Figure 8-11

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Step 1: Active Investors

Definitions

Problems

Solutions

Step 2: Nobel Laureates

Definitions

Problems

Solutions

Step 3: Stock Pickers

Definitions

Problems

Step 4: Time Pickers

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Problems

Step 5: Manager Pickers

Problems

Step 6: Style Drifters

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Problems

Step 7: Silent Partners

Problems

Solutions

Step 8: Riskese

Definitions

Problems

Step 9: History

Definitions

Solutions

Step 10: Risk Capacity

Definitions

Problems

Solutions

Step 11: Risk Exposure

Definitions

Problems

Solutions

Step 12: Invest and Relax

Definitions

Problems

Step 8: Riskese

Step 1: Active Investors

Definitions

Problems

Solutions

Step 2: Nobel Laureates

Definitions

Problems

Solutions

Step 3: Stock Pickers

Definitions

Problems

Step 4: Time Pickers

Definitions

Problems

Step 5: Manager Pickers

Problems

Step 6: Style Drifters

Definitions

Problems

Step 7: Silent Partners

Problems

Solutions

Step 8: Riskese

Definitions

Problems

Step 9: History

Definitions

Solutions

Step 10: Risk Capacity

Definitions

Problems

Solutions

Step 11: Risk Exposure

Definitions

Problems

Solutions

Step 12: Invest and Relax

Definitions

Problems