8.3.1 Active Investors don’t Understand Risk and Return
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.
Because risk is the source of returns, investors would be better served
to be more concerned with the risk level of their investments.
8.3.2 Investors like Comfort and Dislike Uncertainty
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
risk factors.
As is evident in Figure 8-30, it’s uncomfortable
to remain invested in a fund that hasn’t performed well, as doubt
and fear play into investors emotions. It’s also uncomfortable to
pull money out of a fund that has performed well. Greed takes over. It’s
even more uncomfortable to switch money from a fund that’s done
well to the uncertainty and fear of the investment that hasn’t done
so well.
Figure
8-30
 |
Figure
8-31
 |
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 S&P 500 has beat T-bills about 75% of the time in three year periods.
Investors who want more return must incur more risk.
The financial market will price asset classes according to its comfort
level. That is, uncomfortable and riskier asset classes are priced low
enough so that their expected returns are high enough to compensate investors
for the higher risk of holding them. If the market didn’t price
riskier asset classes relatively lower, no one would buy them. Conversely,
those who invest in more comfortable and less risky asset classes such
as Treasury bills or even large growth companies, have lower expected
returns, since financial markets tend to offer less reward to investors
who seek comfort. Huge conglomerates like General Electric are near the
safety level of holding many government debt instruments, consequently,
GE has a low cost of capital and investors should expect a lower return
relative to other smaller, riskier companies.
In short, comfortable investments should produce less return, and uncertain
and uncomfortable investments should produce more return. The prices of
asset classes will reflect this risk/return relationship to ensure that
all securities are held by someone.
8.3.3 Stock Pickers Dilute the Two Most Important Risk Factors
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.
So when a manager goes through the lists of eligible stocks, he often
throws out value and small company stocks because they’re so undesirable.
Even when a money manager specializes in picking value stocks, he typically
leans toward picking the largest, most “growth-like” (lower
BtM) stocks. Similarly, if he picks small company stocks, he tends to
pick the largest small company stocks with the highest earnings.
The problem with this approach is that it dilutes the size and value risk
factors identified by Fama and French. An active manager investing in
a portfolio of value and small company stocks with favorable prospects
holds a portfolio biased towards growth and large company stocks. But
it’s not growth and large company stocks that have the highest expected
returns. It’s value and small company stocks — companies with
the highest costs of capital. That’s why active managers consistently
avoid exposure to these risk factors that generate higher returns. In
doing so, they attempt to achieve higher returns through speculation and
the avoidance of the risk factors that explain returns.
Figure
8-32
 |
Structured investing with index funds is just the opposite. It’s
about an investor’s willingness to take risk in order to earn commensurate
return. As seen in Figure 8-32, there is a clear correlation
of higher returns with higher risks along the line of the 20 index portfolios.
Also note that large growth stocks similar to those on NASDAQ (represented
in IFA/NSDQ), have lots of risk, but very low returns. This is evidence
of the lower expected returns of the growth stocks. Index Portfolio 100
has a fairly high tilt toward small and value stocks and as you see, investors
have been rewarded for holding those risk factors over the last 50 years.
The growth of $1 in Index Portfolio 100 is about $771, while the mostly
large growth companies on IFA/NSDQ grew to only about $97.
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.
8.3.4 The
Myth of the Ideal Investment
Investors clearly
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:
a. statistics
b. probabilities
c. intuition
d. both a and b
e. a crystal ball
2.
Standard deviation is a critical concept for investors because:
a. it identifies the deviant personalities of investors.
b. it explains the standard rule of securities analysis.
c. it describes the uncertainty of obtaining an expected return.
d. it explains 100% of stock market returns.
e. it standardizes stock selection
3.
Risk factors are the most important concept for investors to understand
because:
a. they help them time the market
b. they tell them which active managers are best
c. they identify the source of returns
d. they tell investors what to avoid in their portfolios
e. they eliminate risk in portfolios
4.
If you look at 721 rolling 20 year periods from 1926 to 2006, how often
do micro-cap stocks outperform large cap stocks?
a. 26% of the time
b. 54% of the time
c. 48% of the time
d. 3% of the time
e. 100% of the time
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
come from:
a. large value stocks
b. small growth stocks
c. large growth stocks
d. small value stocks
e. market neutral stocks |
