Step 8: Riskese

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.

Figure 8-23

Time Diversification of Risk

Charles D. Ellis said, “The average long-term experience in investing is never surprising, but the short-term experience is always surprising.” 

Figures 8-25 through 8-27 illustrate this famous quote by Ellis, one of the first proponents of indexing. These charts show 50 years of returns of five different index portfolios in monthly, quarterly and annual periods, and will help investors better understand the time element of riskese. Portfolio 10 is the least risky portfolio, moving up to Portfolio 90 as the most risky. Does time reduce risk? For many years, this question has generated a hot debate among academic researchers and investment professionals. Historical returns have shown that time does reduce risk. 

As the investment time horizon lengthens, the actual average annual compound return achieved by a stock portfolio converges to its expected returns. As the period of measurement changes from monthly to quarterly to annual, the volatility of returns reduces, and the existence of a losing period diminishes.

Figure 8-25

Figure 8-26

Figure 8-27

James K. Glassman summarizes the investor’s dilemma: “In the stock market (as in much of life), the beginning of wisdom is admitting your own ignorance. One of the many things you cannot know about stocks is exactly when they will [go] up or go down. Over periods of days, weeks and months, no one has any idea what [stocks] will do. Still, nearly all investors think they are smart enough to divine such short-term movements. This hubris frequently gets them into trouble.”

Figure 8-29a

Is there predictability of the daily split between gains and losses as compared to the annual return or the years? Not enough to bet on it. See both figures below.

Figure 8-30A

Problems

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.

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 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 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.

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.

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 $327, while the mostly large growth companies on IFA/NSDQ grew to only about $55.

Figure 8-32

Figure 8-33

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.

Solution

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.

Summary

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.

Review Questions

Please answer the following questions before moving on to the next Step:

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 rolling 20 year periods from 1928 to 2011, how often do micro-cap stocks outperform large cap stocks?
a. about 80% of the time
b. less than 3% of the time
c. about 54% of the time
d. about 48% 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