Risk and Return Are Related

Every month, popular financial magazines feature articles that are long on promises and short on substance. The cover stories may offer the lure of finding bargain overseas stocks, learning the secrets of Wall Street pros, positioning for the next bull or bear market, owning the next Google, or trading your way to an early retirement.

All of these (and countless other) headlines have one thing in common. They ignore the reality of how investment markets work. More specifically, the promises advance the false notion that risk and return are unrelated.

We want clients to understand the mechanics of capital markets. By helping them differentiate real investment knowledge from marketing hype, we hope they will have a more secure view of the rationale and strategy driving their investment decisions and portfolio structure. A realistic view of risk-return dynamics and market behavior also may help them apply discipline at crucial times. With this in mind, let’s consider the relationship of risk and return.

Fair pricing in the market

Capital markets are composed of suppliers and users of money. The suppliers are the investors who buy stocks; the users are the companies that need the money for expansion. Investors seek the highest returns possible, while companies want to obtain the capital at the lowest possible price. With millions of people on both sides competing to maximize their benefit, stock prices are consistently moving toward fair value. This is especially true today, with information technology providing near-instant news to market participants around the world.(1)

This efficiency suggests that a stock’s price embodies all public information available on the company, including its perceived risk. An efficient market opposes the traditional Wall Street belief that stocks may trade below actual worth. Finding a stock that offers higher returns without higher risk is an appealing prospect. But you will be hard pressed to find bargains in a global market where professional traders diligently watch for small price discrepancies and act on them quickly.

A more prudent approach is to assume that when a stock trades at a lower relative price and offers higher returns, there’s a good reason. Perhaps market forces deem the company to be riskier and drive down its stock price to reflect this higher risk. In the world of market efficiency, investors who want a higher return must accept higher risk. This applies to stocks and portfolios.

Risk as a return source

Academic research provides strong evidence that risk and return are related. In the late 1970s, Roger Ibbotson and Rex Sinquefield conducted an extensive study of the historical returns of stocks, bonds, bills and inflation. Their calculations of total returns since 1926 and the resulting historical performance charts provided a vivid illustration of the risk-return relationship at work among major asset groups.(2) Their research is updated annually and offers continuing support for a number of key investment fundamentals. These include the following:

  • Stocks, bonds and government securities offer long-term average returns that are in line with their levels of risk. For example, from 1927 to 2006, small cap stocks averaged 12.4% per year, compared to 10.4% for large cap stocks, 5.9% for long-term corporate bonds and 3.7% for one-month Treasury Bills. (3) Perceived risk accounts for these divergent returns. Corporate bonds offer higher yields than government securities because companies may default, while the U.S. government will likely not. In a similar way, stocks of small companies must offer a higher expected return than large, well-established companies because smaller firms are more exposed to industry threats and economic downturn.
  • These return characteristics have endured over the long term. However, over shorter time spans, performance among the riskier asset groups is more volatile, with stocks showing often-large deviations from their average returns, while short-term government instruments deliver more stable returns.
  • During certain periods of history, lower-risk investments have outperformed stocks, although these periods are not easy to predict ahead of time. This does not contradict risk-return fundamentals. Rather, it confirms that all investments have periods of underperformance relative to other asset groups.

This early research set the stage for over 30 years of quantitative work in capital market pricing and stock behavior. Over this period, academic study helped lay the groundwork for a new and improved approach to investing. Research by professors Eugene Fama and Kenneth French was particularly instrumental in this development. They analyzed stock returns to determine whether certain types of undiversifiable risk paid higher returns to investors. Their conclusions are embodied in the Three-Factor Model.(4)

This model proposes that an investment portfolio derives most of its equity performance from relative exposure to three risk sources: the market, company size and stock pricing (or book-to-market valuation). First, investors are systematically rewarded for holding stocks vs. bonds. Second, investors expect higher returns for holding small cap stocks vs. large caps. Third, investors also expect higher returns for holding stocks that are priced lower in relation to their book value (known as “value” stocks or high book-to-market stocks).(5)

The market factor seems intuitive, as most people assume that stocks are riskier than bonds. The other two factors—size and price—are harder to grasp but logical when viewed from the perspective of a lender, such as a commercial bank. A bank offers a lower interest rate to companies that it regards as lower risk. Generally, larger companies and those with healthy balance sheets would receive the best lending terms, while small companies and those with weaker balance sheets would have to pay higher interest rates on borrowed money.

Keep in mind that investment return and cost of capital are two sides of the same coin—an investor’s rate of return is also the company’s cost of capital. As suppliers of capital, investors require returns that accurately reflect the risk they are assuming. As users of capital, companies pay an interest rate or investment return that is sufficient to attract capital providers. In essence, the stock market is applying the same reasoning when it discounts the prices of small cap and value stocks. The lower share prices (relative to other stocks) reflect this higher risk and provide the potential for higher returns as compensation for bearing the risk.

Portfolio Applications

The Three-Factor Model offers a rational methodology for risk-based investing. Also known as multifactor investing, this strategy combines broad diversification and targeted risk factor exposure to build portfolios that efficiently capture higher returns for higher levels of risk assumed.

First, the equity premium earned for being in “the market” is attainable by owning a well-diversified group of stocks. Second, a portfolio can earn an additional premium for holding a greater proportion of assets in small company stocks. Third, a portfolio can be further enhanced by holding a representative group of high Book-to-Market (value) stocks. These risk factors also hold up in the stock markets of other developed countries, which offers further evidence that the risk factors are imbedded in market pricing.

The model offers a number of benefits. Tilting a portfolio’s allocation toward small cap and value stocks can enhance a portfolio’s overall return. Investors receive a higher expected return for taking more risk. Moreover, diversification is the key tool for capturing the systematic risk of the three factors. Investors also have a scientific way to set return expectations, explain their own portfolio’s returns and assess investment manager performance.(6)

Unfortunately, most investors will never implement multifactor investing. Perhaps it does not offer the same excitement or prestige of trading stocks like a Wall Street pro. The false hope of getting something for nothing will lead the unwary to keep seeking out advice in the popular media. Few are likely to receive proportionate rewards. In fact, most will be left confused, disillusioned and primed to embrace yet another unsound strategy dressed up as the latest investment fad.

Developing an accurate view of risk and return—and applying portfolio strategy that implements this view—could make a big difference in their efforts to build long-term financial security.

Endnotes 

1) This state is known as market efficiency. This does not mean that stock prices are exact at any moment—but that the prices are the best estimate, given all the information factored into them by the millions of participants in the market. With near-instant global access to the information that affects a stock’s perceived value, how long might a stock’s price remain higher or lower than expected? The next trade, which may occur within a minute or microsecond, will eliminate that discrepancy.

2) First published in 1977, “Stocks, Bonds, Bills and Inflation” documented their study of historical capital market returns. It became an industry standard for building asset allocation models and measuring performance among institutional investment managers. The charts also helped educate individual investors and introduce asset class investing to the mainstream.

3) Returns reflect annual compound growth rates. Small cap index returns provided by the Center for Research in Securities Prices (CRSP), University of Chicago. Large cap stocks reflect performance of the S&P 500 Index. Long-term corporate bond return quoted from “Stocks, Bonds, Bills and Inflation Yearbook”, Ibbotson Associates. Past performance is no guarantee of future returns. You cannot invest directly in an index.

4) Eugene F. Fama and Kenneth R. French. “The Cross Section of Expected Stock Returns”, Journal of Finance, June 1992, pp 427-465.

5) This ratio compares a company’s book value (defined by standard accounting principles) to its market value. A stock with a high BtM ratio is considered a “value” stock, while a stock with a low BtM ratio is considered a “growth” stock.

6) While this strategy may offer a science-based approach to investing, prudent use of this or any investment model requires careful assessment of risk tolerance and investment objectives, proper diversification, effective management of costs, and a long-term holding period.

 

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