For as long as there have been stock markets, investors have intuitively known that expectations of returns come with commensurate expectations of risk. The higher return one expects, the greater the risk one assumes in order to achieve it. But, it wasn’t until the 1980s and 1990’s that a series of research reports revealed just how important an understanding of risk is in constructing investment portfolios that could achieve above-average rates of return while reducing portfolio value volatility. At its simplest, the deliberate assumption of risk, when applied to a properly diversified portfolio, drives return portfolio performance. In essence, it is through the management of risk, not the management of investments, that optimum portfolio construction takes place and superior long-term returns are achieved.
Here are three risk factors that can be utilized to propel portfolio returns:
3 Risk Factors to Improve Portfolio Performance
1. It’s Better with Beta
Nobel laureate William Sharpe introduced investors to the concept of “beta,” which is a way to explain a stock’s expected return as a function of its volatility (beta) in relation to the whole universe of stocks. If everyone’s portfolio included the whole universe of stocks then they wouldn’t include any beta, thus everyone would earn the same return. By introducing beta, your portfolio will be weighted with more risk stocks with a higher beta and discounted at a higher rate. Portfolio weighted with less risky stocks will have lower betas and their prices will be discounted at a lower rate. In short, if the beta of any investment is higher than the market, then the expected return is also higher and vice versa.
2. For Big Returns, Go Small
In researching Sharpe’s beta theory, it was found that “beta” accounted for 70% of a stock’s return. The other 30% is based on the relative size of the stocks held in a portfolio (as measured by weighted market value) as compared with the weighted market value of the stock market as a whole. Small stocks act differently than larger stocks and generally outperform them over a period of time (but at a higher risk). By factoring in “size” risk, portfolios that include a weighting of value stocks (which outperform growth stocks) and small cap stocks (which outperform value stocks), a portfolio can generate higher rates of return over time.
3. Price-to-Book Value can Unlock Better Values
The third factor, price-to-book value, compares the amount of volatility in value stocks with the market as a whole. Value stocks tend to be larger companies with lower earnings growth rates than growth stocks. They are also more likely to pay higher dividends, so their book value tends to be higher when compared to their price. Fama-French found that value stocks act differently than growth stocks, and that, over time, value stocks have outperformed growth stock, but again, at higher risk.
In summary, there are three main factors – Beta, Size, and Price-to-Book Value – driving expected returns in a portfolio. Because these three factors can determine more than 95% of the return of a diversified stock portfolio versus the market as whole, it is now possible investment managers to engineer a portfolio in which investors’ receive an average expected return (above the guaranteed T-Bill rate) according to the relative risks they assume in their portfolios.
Disciplined investors accept the fact that there is risk in the markets and the chance of experiencing negative returns in their portfolio at one time or another is a very real likelihood. They know that the longer they hold their portfolio, the more likely they are to experience extended periods of negative returns but they also know that the longer they hold their portfolio, and it is properly diversified with all risk factors considered, the greater the likelihood that their compounded annual return will be positive.’
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