“There are three kinds of investment risk. Two can be virtually eliminated. The third, market risk, must be managed."
-Charles Ellis, Winning the Loser's Game
Risk: A Primer
In his book Index Funds: The 12-Step Program for Active Investors, Mark Hebner identifies that 85% of investors are active investors. This means that a majority of investors handle their investments in one or more of the following ways:
- They pick stocks or hire the latest hot fund manager to pick stocks for them.
- They think there are times to be in a market and times to be out of a market.
- They shift in and out of styles or indexes in an effort to chase returns
There are many problems associated with these types of strategies, but let's limit this discussion to the fact that these approaches make poor use of risk. The risks that active investors take are generally and uncompensated.
Certainly, investors have an all too fresh understanding of the brutality of the equity markets, and many are reeling. Many are victims of flawed strategies, and they will continue to be until they learn how to implement the right amount and types of risk.
How can investors assemble a risk-appropriate portfolio?
Every investment carries an expected return and an uncertainty of that return. This is true of stocks and indexes. Most people who pick stocks think that they can find the handful of stocks that will do better than the index and avoid the stocks that will do worse than the index. This hope is based on the belief that stocks are mispriced (either overpriced or underpriced) and that they can exploit those mispricings for profit.
Eugene Fama is widely regarded as the "Father of Modern Finance." Among his many important and ongoing contributions to the financial markets is The Efficient Market Hypothesis which explains how and why markets work.
Fama's research shows that securities are fairly priced at all times, with the price agreed upon by a willing buyer and a willing seller to be the best indicator of a stock's value. The free-flow of information, research and analytics available to 6 billion market participants and all at the same time makes it virtually impossible for any one investor or analyst to possess an edge over all other market participants beyond that which would be expected by chance alone. In other words, investors cannot enjoy excess profits from picking stocks or actively managed funds. (See Eugene Fama Jr. explain efficient markets and the dimensions of risk.)
One of the implications of Fama's hypothesis is that every stock within an index has the same expected return as the index, but individual stocks carry more uncertainty of that return, or higher risk in the form of company risk such as fraud allegations, accounting issues, etc. An example of this type of risk is Enron which had issues specific to the company alone that brought down the energy giant. In contrast, the S&P 500 index which had an allocation to that company's stock was able to absorb the shock and earn that market's rate of return.
In Winning the Loser's Game, Charles Ellis describes stock group risk, which should also be diversified away in order to reduce unnecessary or uncompensated risk. Stock group risk is present when an investor owns multiple stocks, but as a group move up and down in price. This is called correlation. Portfolios that are highly correlated carry excessive concentration risk, and are not well-diversified. (see Nobel Prize Winner Harry Markowitz explain diversification).
How can investors make the most of risk?
All returns come from risk, but not all risks carry expected returns. How can investors feel certain that they are taking only those risks that have shown to carry return and leave the rest aside?
Take the Risk Capacity Survey
Fama and French's Three Factor Model identifies the source of stock market returns: market, size and value. Alpha measures a manager's skill in earning an average excess return that couldn't have been achieved through an index with risk exposures similar to the portfolio run by the manager. In short, did the money manager earn anything above the indexed return once the three factors have been accounted for?
The above chart tells us that a portfolio's expected return is determined by the portfolio's exposure to the market as a whole, as well as to the extent to which that portfolio is exposed to small and value factors. A globally diversified index portfolio that captures the right amount of these specific risk factors is an excellent method to implement efficient use of risk and to mitigate uncompensated and excessive risks that come with active investing.
So, how has a portfolio with varying and risk-appropriate exposures to market, size and value factors performed over time?
The chart below depicts the Roller Coaster of Risk and Return. It shows the volatility of five Index Portfolios (IFA Index Portfolios 10, 30, 50, 70 and 90) as measured by annual returns for the 50-year period from January 1959 through December 2008, as well as the growth of a dollar.
As you can see, Index Portfolio 10, with a large allocation to fixed income, had a much smoother ride than the all-equity Index Portfolio 90 for the 50-year time period, but with far less return.