One of the fundamental tenets of a successful stock portfolio is solid diversification to manage risk. The phrase “higher risk, higher reward” is used in the general sense to set ratios between riskier stocks and more stable bonds and cash holdings.
Investors adjust their risk according to their station in life. As you get older, you cannot afford to take a hit in the stock market that you do not have time from which to recover. However, this viewpoint looks at only one aspect of risk – price volatility.
A recent study by the investment management firm GMO suggests that the classic risk/reward correlation has flaws. By reviewing over thirty years worth of previous data on U.S. stocks, the analysts discovered that the most volatile 25% of stocks produced a nearly 7% annual return on average. During the same period, the least volatile 25% of stocks returned 10.6% annually.
If the data set is shortened to more recent years (1984-2011), the differential widens. Volatile stocks returned 4.1% annually versus 10.1% for more stable stocks.
Bloomberg and the Financial Times suggest that this finding indicates a fundamental shift in market operation, driven by the shift from individual stock ownership towards institutional ownership with performance benchmarks.
The benchmark reference will be an index of some sort, whether the funds involved are passively or actively managed. Pressure on fund managers to stay close to the index dictates that managers will keep average positions (weights) in stocks that are both volatile and a large component of the index. Consequently, the risk premium is dampened.
Others ask if this analysis even matters, since there is more to risk than just volatility, which is easy to measure and thus is usually used to define risk. However, on a larger scale there is a risk that is more difficult to quantify – not the magnitude of short-term price fluctuations, but the price dropping catastrophically and perhaps reaching an unrecoverable level. The flip side of this is a disproportionately large and permanent reward, such as a startup that hits it big.
A study by Professor Campbell Harvey of Duke performed a similar analysis to the GMO effort but including “tail risk”, or the probability of an excessively large event such as a halving or doubling of the price. This represents the larger scale risks listed above, and by introducing probabilities, the study is more predictive than backward looking (or based solely on past volatility data).
To look at it differently, both a fundamentally flawed and a fundamentally sound company could have the same volatility based on sentiment and demand, but one of those companies truly poses a greater risk while the other may present a greater opportunity.
Professor Harvey found that with tail risk and other factors included, stocks with higher tail risks produced higher returns than those with lesser tail risks. The studies are not contradictory; they represent different definitions and measurements of risk.
Since risk means different things to different people, what should you do as an individual investor when assessing risk? Start by analyzing your results. If they aren’t broke, don’t fix them. If you are not getting the results you want, consider if your definition of risk and the corresponding philosophy differs from that of your fund manager.
Most importantly, stay diversified in the broader sense of risk – because while these studies may spar over the relative risk in different stocks, nobody is applying this concept between stocks and bonds. Experiment within your stock holdings if you want, but stay diversified on the macro scale.