Risks and Rewards

In investments, it’s often thought that risks and returns are often interlinked and highly correlated, i.e. low-risk investments have low returns and vice versa.  However, nothing is further from the truth.  The reason is not all risks are rewarded and not all low-risks instruments have low rewards.  Some investments have tremendous amount of volatility but are poorly compensated.  These are poor investments most of the time unless you’ve reasons to include them in your portfolio.

A more educated view is that the intelligent investor should take calculated risks which are well worth exposing your portfolio to.  In academia speaks, we should invest in securities with high risk-adjusted returns.  Risk-adjusted returns are measured by calculating the Sharpe ratio of that particular security or portfolio.  The formula for Sharpe ratio is the excess returns of the security above the risk-free rate divide by the volatility of the same instrument.  The risk-free rate is usually the interest rate of the short term government bond.  The volatility is measured by calculating the standard deviation of the stock/bond over a period of time.

The followings are example of the different types of risks and their impact to the portfolio returns.

Individual security/unsystematic risks – unsystematic risks related to the idiosyncratic behavior of individual stocks/bonds which can be diversified away by owning a wide portfolio of disparate stocks/bonds.  Because you can diversify away such risks, unsystematic risks are not rewarded by the market.  If you get high returns by owning a non-diversified portfolio, it’s because of the investing four-letter word – luck.  Not putting all your eggs in one basket is such a no-brainer application that all investors with IQ’s above room temperature should comply with (I’m talking about degree Celsius and not Fahrenheit).

Systematic/market risks – this is the opposite of individual stock risks mentioned above.  Systematic risks are risks that you cannot diversify away.  No matter how many gazillion stocks you own, the securities of the portfolio will fluctuate according to the sentiments of the markets.  For those who notice, the fluctuation can be pretty wild.  The best weapon against such risks is to invest for the long term.  We should hold onto stocks and let the up years and the down years cancel out each other over the long run and arrive at an average result.  Short-term funds should not be committed to the stock market because of this reason as evidences from the professional fund managers show that it’s impossible to time the markets.  Attempts to predict the ups-and-downs of the markets are often futile net of costs.  Market risks are very well rewarded as can be seen from the multi-folds increase in popular stock indices such as the S&P500 index over the very long term.

Credit/default risks – this relates to the failure of a debtor to pay the bond/preferred stock its interest coupons or principal.  The company in question usually faces financial difficulty or is in default.  These types of bonds are frequently in the junk bond category and have poor credit ratings.  Assessment of credit risks is pretty much a complex process and you need to evaluate the terms/covenant of the bonds and the future earning capability of the company to see whether the company can fulfill its obligations.  The conservative investors who have not much interest in analysis is best advised not to take up too much credit risks as it’s more of an art than a science.  If he seeks higher returns, instead of going for high-yield bonds, he is advised to expose this part of the portfolio to equities.  Of course, it might be the case that the credit risks rewards are so high in future that it exceeds the returns from equities but such is not the case right now.  High-yield bonds have ceilings on returns as per the terms but high ups-and-downs in prices.

Term risks – most of the time, longer-term debts have higher interest rates than shorter-term debts.  This is likely because longer-term bonds have higher volatility in the secondary markets than shorter-term bonds.  Investors are advised to take short-term bonds (less than 5 years), or at most intermediate-term bonds (up to 10 years).  This is because long-term bonds of up to 30 years are highly volatile and have stocks-like behavior in this regards.  However, the long-term bonds do not have the attractive returns characteristics of stocks.  Such an assessment might of course change in the future, but as of now, especially in this low-interest rate environment this can’t be truer.

Beta risks – beta is a highly complex finance tool.  To put the long story short, it’s a tool to measure the relative volatility of a stock against the benchmark.  High beta stocks move more aggressively than the benchmark and vice versa.  The general consensus of this facility is that the beta curve is more or less flat, i.e. some researches show that as the betas of stocks increase, the returns increase only very minimally, whereas other researches show that as the betas of stocks increase, the returns actually reduce.  Thus, most professionals advise that either the investor diversifies as widely as possible or take a low-beta approach.

Emerging-market risks – emerging markets such as China, Brazil, India, Russia and South Africa are the brave new world of the stock markets.  Because these are developing countries, they might be less researched, less efficient and have poorer financial disclosure.  These countries also have political and currency risks.  Emerging markets have a shorter history than developed markets, but evidence from these stock markets shows that a diversified portfolio of emerging market stocks yields higher returns at a correspondingly higher volatility compared to developed markets.  You should be able to get better returns investing in emerging markets when valuations of those markets are low provided you can stomach the zigs and zags of the prices.

Small-cap risks – over the history of the US financial markets, small-cap stocks have out-performed large caps with a higher volatility.  At the company level, small-caps are capital inefficient compared to large-caps as can be seen from the lower return-on-equity figures for small caps.  However, at the stock level, because small-cap stocks are lowly priced, they have higher returns to the investors than large-cap stocks.  Thus, investors with a long horizon can profit from small-cap exposure.  Do not be deceived by the word ‘small’, a lot of funds that specialized in small-caps buy companies with capitalization of USD 1 billion or more.  Small is a relative term, if you want to be smaller than that, you’ve to invest in a micro-cap fund.

Value/growth risks – Value stocks, i.e. companies rich in earnings and assets relative to prices, perform better over the long term compared to growth stocks.  Notwithstanding the higher returns, value stocks do not show much higher volatility (measured by standard deviation) compared to a market index such as S&P500.  If you want to improve upon the market portfolio without taking too much extra risks, value-oriented investing is the way to go!

Leverage risks – not leveraging against the portfolio is a no-brainer as you could face margin calls to liquidate the portfolio in times of distress – exactly the time when you should not divest.  It’s also not a good idea to invest in highly-leveraged companies.  Those companies drowned in debts might shoot up during bull markets but later go into a tailspin in bear markets.  The best examples are highly-leveraged banks during the financial crisis from ’07 till ’09.  By the time they’ve de-leveraged after the crisis a large part of their equities are already eaten up by non-performing loans.  They’ll probably take many years before the banks can regain their glory before the crisis.  It appears that the leveraging and de-leveraging of the American banks are systemic, you cannot diversify that risk away by investing in as many banks as you can find.

Expense ratio – this is not a risk per se but voluminous evidences show that expenses are something you pay for nothing.  High expense ratio funds underperform low expense ratio funds.  The overwhelming consensus is that the index funds are the best deal in town.

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