Jun 16, 2006

Risk and Return are Related

by: Stephen Lowrie

It’s official - the TSX Composite Index has “officially” experienced a correction. A correction is usually defined as more than a 10% pullback. While any correction is un-predictable in advance, some sort of pullback was not unexpected. It has been 959 consecutive trading days (since October 2002,) without a correction of 10% or more - the longest consecutive period of days in 35 years.

My only prediction (… given how I feel about forecasts and predictions in general,) is that this recent pullback is probably just a “correction” as opposed to some sort of extended market decline.

This recent volatility presents a good opportunity to talk about risk. Investors and financial advisors have different definitions of risk. Some say its volatility, some say it’s a risk of losing capital, and some say it’s the risk of out-living your capital. The only thing constant with these definitions is that people’s risk tolerance changes depending on market conditions. When things are good and people are making money, they are willing to take on more risk. When markets go down and people start losing money, they tend to become very risk-adverse.

It may seem as though I am stating the obvious, but risk and return are related. What some people forget is that if they are going to take on risk, then they want to be rewarded, i.e. earn a higher return or some sort of “premium” for doing so. If there were no opportunity to earn some sort of premium, then why would you bother taking the risk in the first place? Furthermore, you want to make sure that the potential premium is high enough to make the risk worthwhile.

These comments may seem very general, but can have broad implications for portfolio management. Rather than relying on economists and the analysts of the day, let me turn to some academic work on risk and return.

Academics usually use something called the “risk free rate” as a starting point. . This is basically the rate of return on a high quality, 90-day government t-bill. Essentially, these t-bills are risk-less, i.e. unless the government of Canada goes bankrupt in the next 90 days you will receive a guaranteed return. This risk-free rate changes over time, as interest rates go up and down. Currently in Canada the “risk-free” rate is around 3.75%. This is important because this risk-free rate should be used as a benchmark to compare the returns offered by other investments.

To earn a return higher than the risk-free rate, investors have to take on some risk. Work done by Fama / French suggests that the vast majority (over 95%) of the variability of returns in stock and bond portfolios can be explained by 5 factors. Let me summarize these in relation to the risk free return:

Bond risk premiums
• Term factor – Longer-term bonds have a higher expected return than shorter-term bonds. Historically, this has been around 1.5% - 2% per year above the risk-free rate.
• Default factor – Lower quality bonds (corporate bonds) have a higher expected return than higher quality bonds (government bonds). Historically, the premium of corporate bonds over government bonds has only been around .25% per year.

Equity Risk Premiums
• Market Factor - Stocks have a higher expected return than bonds. Historically, this has been around 6% per year above the risk free rate.
• Size Factor – Small stocks have a higher expected return than big stocks. Historically, the size factor has added about 1-2% to the market factor.
• Price Factor – Stocks with lower valuations (i.e. lower Price/Earnings, Price to Book value) have a higher expected return than stocks with high valuations. Historically, the price factor has added about 2-3% to the market factor

The risk with all of these premiums is that they aren’t consistent over all periods. For example, there are periods - sometimes long periods - when these premiums are negative. To put this in perspective, historically, the standard deviation (a measure of volatility) of the Size and Price factors has been as high as the Market factor. If these premiums were consistently positive, then there would be “free-lunch” for the taking. Unfortunately, there are no “free lunches” in the financial markets. It’s this fact that creates the risk.

The nice thing about the 5 factors is that is explains such a high percentage of the differences in returns. That is not to say that other factors do not influence returns, just the actual amount is rather insignificant. A few these “over-rated” factors, i.e. risk factors that investors are not rewarded for taking are market timing, stock picking, and hiring managers to actively pick stocks. This raises the question again, that if you are not going to be compensated for taking some factor risk, why would you ever take it in the first place!

It should be noted that every time we have any market correction people look at these types of “over-rated” factors as if they are some sort of Holy Grail to preserve their capital. The problem is that these factors don’t add value over time. If anything, they add a speculative risk or uncertainty to your portfolio. For example, some active managers have gone down less than the market recently, but some have gone down more. Unfortunately, regardless of claims that many people make, it is almost impossible to predict who will out- or under-perform in advance.

The good news is that these premiums are available for all investors to take advantage of. But, investors only earn these premiums over long periods of time. The bad news is that to earn these premiums, investors have to live through these market corrections.

Where do we go from here?

As a regular review process, I am always looking at all portfolios in the context of the 5 risk factors. This is to make sure that every portfolio is structured to maximize returns for a given level of risk or conversely lower risk for a given expected return. Given some recent work I have done on expected risk premiums, this process will likely entail the reduction or complete elimination of a few asset classes or specific investments that don’t fairly compensate for risk.

In the meantime, by the time a correction has already occurred, there are not really many constructive things investors can do. Put another way, the horse has already left the barn so closing the door will not help at this stage. Therefore, I recommend staying the course, as you will be rewarded for doing so!