In the six decade-history of modern finance, the basic lesson is that risk matters. Managing risk, in other words, is more productive than chasing return. But what exactly is risk? Alas, there are no easy answers, but at least there’s a beginning.
Financial economics has been uncovering what risk means for decades, refining our understanding of financial hazard and, more importantly, how it’s priced and what it all implies for portfolio design. At the basic level, market risk—beta—is the elephant in the room. Unless you’re willing to hold extreme portfolios—a handful of securities, for instance—beta will cast a long shadow over risk and return.
Long but not absolute. Market beta can’t be dismissed, but neither does it tell the whole story. There are other risk factors under the sun, and several are worth considering for most investment strategies. It’s widely accepted that asset pricing is driven by multiple risk factors, albeit in varying degrees. But which ones should we consider? As a starting point, there’s a trio worthy of routine focus when it comes to designing and managing equity portfolios.
“Most investment practitioners believe that there are three factors that explain security returns and that these factors correspond to the Fama-French three-factor model,” writes Professor Craig Rennie in the Handbook of Probability. “This model suggests that beta, growth opportunities (usually measured by firms’ market-to-book ratios), and firm size determine most of the differences in expected returns of risk assets.”
In other words, a large if not dominant degree of how your stock portfolio performs over time is a function of the exposure to three risk factors: the equity market overall, small-cap stocks, and value stocks. By adjusting this mix, you can engineer higher expected returns relative to owning a conventional market-cap index fund. In other words, holding small cap stocks and/or value stocks in excess of their market-cap weights boosts expected return. In fact, if you analyze equity mutual funds that “beat the market,” you’ll find that most have done so by overweighting the small-cap and/or value factors. This isn’t guaranteed, of course, but then again nothing else is either when it comes to risk factors. And even if the 3-factor risk model pays off over the long run, as history and a small library of research suggests, the associated risk payoff is likely to come in fits and starts.
There are other factors, of course. A popular fourth factor is momentum, or the tendency of stocks with gains in recent history to continue rising, and vice versa. “If you form portfolios on stocks that have gone up in the last year, this portfolio continues to do well in the next year, and vice versa,” notes Professor John Cochrane in the Handbook of the Equity Risk Premium. Mark Carhart was the first to extend the Fama-French 3-factor model with momentum, a.k.a. the 4-factor model.
In fact, momentum as a factor reached a milestone of sorts by way of formal targeting in publicly available index funds. AQR Capital Management launched a trio of momentum-based index funds last year. Reportedly, these are the first of their kind for the general investor.
Stepping back and considering the four factors, the implication is that there’s greater opportunity for managing risk on a more granular level. In turn, there’s more opportunity for generating a return above what’s offered by a conventional market-cap index funds. In fact, there are more factors to consider, such as volatility, dividend yield, etc. There’s also an expanding menu of products that zero in on specific risk factors.
In a world of multiple risk factors, the central challenge is managing the mix through time. For most investors, this is a challenge that threatens to overwhelm, depending on how many factors you target. In addition, there’s the possibility if not the inevitability of making serious errors in emphasizing this or that factor at the wrong time. In sum, the possibility of earning something less than the market portfolio’s return is matched by the chance for earning more for the average investor.
Yes, it’s still all about risk. Asset pricing research has turned up amazing insights over the years, offering investors a deeper understanding into the sources of risk premiums. But the fundamental lesson remains: the chance for earning a higher return comes linked with the chance of earning less than you would with a simple market-cap index fund.
What’s more, you’ll have to work harder at earning a bigger risk premium. As I explain in Dynamic Asset Allocation, there are lots of moving parts to managing money in a world of multiple risk factors. Relatively few who venture down this path will succeed on a net basis (i.e., after taxes, trading costs, etc. and adjusting for risk). The first question in the money game is asking yourself: Am I smarter than the average investor?