High risk exposure is like a scream inducing roller coaster with soaring highs and stomach churning lows. Investors should hop on a milder ride if they don’t like the extreme rush of the one they’re on. The same concept applies to investing. However, not everybody has the capacity for such exposure to risk. The left side of Figure 8-23 shows the roller coaster like returns of four different index portfolios. The red colored Index Portfolio 100 has higher highs and lower lows than the other lower risk portfolios. Also, note that the growth of $100,000 over 50 years is higher for the higher risk Index Portfolio 100. The right side of Figure 8-23 shows what the one index of small value stocks looks like on the same scale. These graphs provide a vivid illustration of the concepts of risk, return, and time. A dynamic version that allows movement, selection options and has updated data is shown below.
Charles D. Ellis said, “The average long-term experience in investing is never surprising, but the short-term experience is always surprising.”
One of the primary
deterrents to investors earning market rates of returns is their lack
of understanding of the relationship between risk and return. The natural
tendency is to want returns without risk.
The notion of loss
aversion forms the basis for how investors make trade-offs between risk
and return. The pricing system that’s at the heart of free market
capitalism, reflects this trade-off as the market sets prices for different
Based on these simple
observations, it’s easy to see that investors like comfort and excitement
of investments that have done well and dislike the uncertainty, doubt
and fear of those that are not doing well. Since this is the case, the
likely conclusion would be that all investors would simply hold Treasury
bills, but you can see in the second column of Figure 8-31,
the Large Blend Index, or Simulated S&P 500, has beat Treasury Bills about 75% of the time in three year periods.
Investors who want more return must incur more risk.
The primary role in
the life of active money managers is to pick winning stocks, but they
usually avoid picking high BtM value (distressed) and small company stocks.
Why? Because investing in value and small company stocks is about investing
in companies with some degree of financial distress that’s often
evidenced by poor earnings.
An active manager who picks value and small company stocks often must explain to their clients the reasons he bought “doggy” value and small company stocks with bad earnings. Usually the explanation falls on deaf ears. In order to retain the client’s business, the money manager, more often than not, must invest in large company and growth stocks—stocks with good earnings, but lower expected returns.
Figure 8-33 reminds us of the value of diversifying beyond large cap companies in the US, like the S&P 500.
like return and dislike risk. So, an ideal investment would be something
that provides a 40% return year after year, isn’t volatile, is liquid,
and is tax-free. Unfortunately, such an investment doesn’t exist.
Markowitz’s insight that investors should be concerned with risk
as well as return is the next best thing to a riskless, high return investment
because it’s the basis on which investors can build their portfolios
using the clear risk and return trade-offs of different asset classes.
If an executive has business to do in China but does not speak Chinese,
he hires an interpreter. If a businesswoman is engaged in a complicated
transaction, she hires a lawyer who is fluent in legalese. The same is
true for investing. Few investors understand that knowledge of riskese,
the language of risk, is extremely important in investing and actually
correlates with returns. The higher the knowledge, the higher the expected
returns. It would be advantageous for investors to learn as much as they
can about risk and work with an investment advisor who has a strong statistics
and risk knowledge base.
With risk as the currency of returns, investors need to understand the
denominations or dimensions of risk. Once these are more clearly understood,
investors will welcome the dimensions of risk in the proper doses.
1. When academics study the stock market, they apply the principle of:
2. Standard deviation is a critical concept for investors because:
3. Risk factors are the most important concept for investors to understand
4. If you look at rolling 20 year periods from 1928 to 2011, how often
do micro-cap stocks outperform large cap stocks?
5. Eugene Fama and Kenneth French looked at stocks on two key dimensions
of risk and return. They concluded that the highest returns for investors
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