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Risk and Return
The art of "investing" is defined by risk and return. An investor is willing to assume a certain amount of risk as a trade-off to getting paid an expected return. It is quite important for any person, prior to jumping into the stock market, to understand the different types of risk and how to measure them. As we will see, some types can be circumvented through diversification, while others cannot. Be sure you are getting paid for the added risk you take!
When an investor buys a security (stock, bond, mutual fund, artwork, etc) they have a certain "expected return." Some investors may quantify this number as a percentage, while others just hope for some sort of positive return. Expected return is mathematically defined as income + capital appreciation. Certain stocks, generally in the technology sector, do not pay any income (dividends) because they reinvest all profits in their business. In the case of these (growth) stocks, your expected return is strictly capital appreciation. Keep in mind that investing is a two-way street between the investor and the company you are investing in. If you buy a stock position in a company (or a bond from them) they have to give you an adequate reward for doing so or you'll invest elsewhere. Thus, the "required return" is what will induce an investor to invest in an asset, given that asset's level of risk. There are a few types of risk:
systematic risk- this is risk which cannot be diversified. When you buy a security it is subject to the following unpredictable factors which may affect (either positively or negatively) your return on investment: interest rate risk, reinvestment rate risk, market risk, exchange rate risk, and purchasing power (inflation) risk. There is nothing you can do to protect an individual stock from an inflationary period. Please note that even though you cannot prevent these risks, there are still ways to hedge them. An example would be buying a floating rate mortgage security to protect a stock which may tend to perform negatively in a rising interest-rate environment.
unsystematic risk- this component of risk can be diversified by having a "portfolio" of securities. Diversifiable risks include business risk, financial risk, and country risk. For example, if you have $10,000 and buy a homebuilding stock with it, you are not diversifying your risks. If the overall stock market goes up, but the housing sector slows down, your stock will underperform the overall market. Many investment professionals believe that owning a basket of roughly 10-15 stocks in different sectors can eliminate most of the unsystematic risk.
The most important measure of a security's risk is its standard deviation. This is a statistical measure of the historical volatility of a portfolio of securities, usually figured with a 5, or 10-year return. In simpler terms, standard deviation is a measure of how much investment returns tend to fluctuate around their average. To compute standard deviation, you need to write down the % return each year for a specific stock or mutual fund. You then add them all up and divide by the number of securities you are using. This will give you the "mean" or average return of the portfolio over a period of time. You subtract the mean from each annual return and then square it. You add up all these squared numbers, divide by the number of years, and take the square root. This will give you the "standard deviation." A portfolio will move within 1 standard deviation (whatever the number is) 68% of the time. It will move within 2 standard deviations 98% of the time. This is an important way to assess potential risk and return from a portfolio of securities. Check out this profile page from yahoo.com which goes into the statistical measure of “risk.”
Risk
Risk means the probability that you will lose money on an investment. A more technical definition of risk is the volatility of return on the investment. An asset with erratic returns is considered riskier than an asset whose value is static or moves slowly.
Few investments are risk-free. Investing in stocks, in particular, means accepting some level of risk. If you want to make a killing in the stock market, you are going to have to take risks. If you keep all your life savings in safe investments such as a savings account, you will face virtually no risk, but your returns will be small, and inflation will eat away at the value of your deposit.
There is a trade-off between risk and return. Less risk means less return, while taking on more risk brings the possibility of a higher return.
Levels of risk are a personal decision. They may be affected by your age, investment goals, time of life and how much you can afford to lose.
Types of risk
There are two types of risks to consider when investing in the stock market - the market risk and unique risks.
Market risk
The values of individual stocks often tend to move in the same general direction as the overall market. And it is unusual for individual stocks to move markedly against the movement of the FTSE 100. That's because they are all driven by the same factors that affect the overall health of the economy (inflation, interest rates, GNP figures, etc). There is obviously a risk that the market overall could fall. That is called the market risk.
Unique risk
Unique risk is specific to a particular stock. For example, if a car manufacturer's production is disrupted by a strike, it would be a source of unique risk because it would only affect that particular manufacturer. Other sources of unique risk include mistakes by company management, new inventions by a competing company and law suits.
Risk and return
In general terms, the riskier an investment, the higher return an investor should expect for taking on that risk.
An investment risk is the possibility that the security (stock or bond) will default or depreciate significantly in value. But in order to assess just what return is required to compensate you for taking a risk, you need to work from a benchmark rate. This rate is known as the risk-free rate.
Risk-free rate
The risk-free rate usually corresponds to the rate available on a risk-free investment. In most cases it corresponds to the rate paid on long-term government bonds, which are considered relatively risk-free.
Risk premiums
The risk premium is essentially the reward an investor expects for taking on risk. This premium depends on the amount a security can be expected to deviate from its purchase price.
Risk-adjusted return
Higher-risk investments (such as small-cap stocks) can be expected to be far more volatile than a government bond, so investors will expect a return - for example, 15% - greater than the risk-free rate.
If a government bond provides a return of 5%, then the risk-adjusted return for the higher-risk investment is 15% - 5% = 10%.
Risk-adjusted returns are not quoted anywhere because they are theoretical, but try to apply the concept when making investment decisions. Estimate the risk-adjusted return by comparing the investment return you are looking at with a risk-free return. Then you need to decide if that return is adequate compensation for taking on the risk.
Reducing risk
Unique risk
Diversification can reduce the unique risks of individual investments. That means spreading your money over a number of investments.
Market risk
Diversifying your portfolio will not eliminate market risk. You may be able to reduce market risk by switching your money into less risky investments such as government or savings bonds, but you will have to settle for lower returns.
Risk and Return
• A security's return is often measured by its holding-period return: the change in price plus any income received, expressed as a percentage of the original price. A better measure would take into account the timing of dividends or other payments, and the rates at which they are reinvested.
• The total return on an investment has two components: the expected return and the unexpected return. The unexpected return comes about because of unanticipated events. The risk from investing stems from the possibility of an unanticipated event.
• The total risk of a security refers to the extent to which realized returns may deviate from the expected return. A common measure is standard deviation, although for many investors the downside risk is more important than the sheer dispersion of returns. For funds managers, the risk of underperforming a benchmark may be the most relevant risk.
• If one assumes returns are nomally distributed, then variance (or its square root, standard deviation) is a reasonable measure of risk, since a normal distribution is symmetrical and fully described by its expected value and variance. There is evidence that stock-price returns are more leptokurtic (fat-tailed) than would be predicted by the standard normal distribution.
• Systematic risks (also called market risks) are unanticipated events that affect almost all assets to some degree because the effects are economywide. Unsystematic risks are unanticipated events that affect single assets or small groups of assets. Unsystematic risks are also called unique or asset-specific risks.
• Investors face a trade-off between risk and expected return. Historical data confirm our intuition that assets with low degrees of risk provide lower returns on average than do those of higher risk.
• Shifting funds from the risky portfolio to the risk-free asset is the simplest way to reduce risk. Another method involves diversification of the risky portfolio.
• U.S. T-bills provide a perfectly risk-free asset in nominal terms only. Nevertheless, the standard deviation of real rates on short-term T-bills is small compared to that of assets such as long-term bonds and common stocks, so for the purpose of our analysis, we consider T-bills the risk-free asset. Besides T-bills, money market funds hold short-term safe obligations such as commercial paper and CDs. These entail some default risk but relatively little compared to most other risky assets. For convenience, we often refer to money market funds as risk-free assets.
• A risky investment portfolio (referred to here as the risky asset) can be characterized by its reward-to-variability ratio. This ratio is the slope of the capital allocation line (CAL), the line that goes from the risk-free asset through the risky asset. All combinations of the risky and risk-free assets lie on this line. Investors would prefer a steeper sloping CAL, because that means higher expected returns for any level of risk. If the borrowing rate is greater than the lending rate, the CAL will be "kinked" at the point corresponding to investment of 100% of the complete portfolio in the risky asset.
• An investor's preferred choice among the portfolios on the capital allocation line will depend on risk aversion. Risk-averse investors will weight their complete portfolios more heavily toward Treasury bills. Risk-tolerant investors will hold higher proportions of their complete portfolios in the risky asset.
• The capital market line is the capital allocation line that results from using a passive investment strategy that treats a market index portfolio such as the Standard & Poor's 500 as the risky asset. Passive strategies are low-cost ways of obtaining well-diversified portfolios with performance close to that of the market as a whole.
Interest Rate Risk
• Even default-free bonds such as Treasury issues are subject to interest rate risk. Longer term bonds generally are more sensitive to interest rate shifts than short-term bonds. A measure of the average life of a bond is Macaulay's duration, defined as the weighted average of the times until each payment made by the security, with weights proportional to the present value of the payment.
• Macauley's duration measures the time horizon when a bond's yield will be realized. During that time, losses (gains) from price change will be offset by gains (losses) from reinvestment of coupon interest.
• Modified Duration is a direct measure of the sensitivity of a دوره دوام bond's price to a change in its yield. Modified Duration is equal to Macauley's Duration/(1+yield).
• Duration is only an approximation of the percentage price change of a bond for a 1% change in yield. It assumes parallel changes in a flat yield curve, and only works for small changes (such as 10 basis points) in yield.
• The longer the maturity, the lower the yield, and the smaller and less frequent the bond's coupon, the greater is the duration. The Macauley's duration of a zero-coupon bond is equal to its maturity.
• Convexity measures the degree to which duration changes as the yield to maturity changes.
• Positive convexity, which characterizes most straight (plain, non-callable) bonds, refers to the fact that price sensitivity, as measured by duration, declines as the yield increases, and rises as the yield decreases. Positive convexity is regarded as a desirable feature of a bond, particularly when yields are volatile. Callable bonds such as US mortgage-backed securities have negative convexity over some yield range.
• Duration is additive, so the duration of a portfolio of bonds is the weighted sum of the duration of the individual bonds. Because duration and convexity measure price risk, they can be helpful in bond portfolio management.
• Immunization strategies are characteristic of passive fixed-income portfolio management. Such strategies attempt to render the individual or firm immune from movements in interest rates. This may take the form of immunizing net worth or, instead, immunizing the future accumulated value of a fixed-income portfolio. Immunization of a fully funded plan is accomplished by matching the durations of assets and liabilities. To maintain an immunized position as time passes and interest rates change, the portfolio must be periodically rebalanced.
• A more direct form of immunization is dedication or cash flow matching. If a portfolio is perfectly matched in cash flow with projected liabilities, rebalancing will be unnecessary.
Quantifying Credit Risk
• For many years, academics and financial insitutions have sought to predict losses from credit risk. The best-known methodogy is based on Altman's Z-score, which seeks to predicts defaults using company financial data.
• The newer CreditMetrics approach estimates volatility from upgrades, downgrades, and defaults. Historical data are used to attribute a likelihood of possible credit events, including upgrades and downgrades, not just defaults.
• For example, CreditMetrics calculates the probability that a bond’s current rating will shift to any other rating within a given time. Each shift results in an estimated change in value (derived from historical credit spread data or recovery rates in default). Each value out-come is weighted by its likelihood to create a distribution of value across each credit state, from which each asset’s expected value and volatility of value is computed.
• To compute the volatility of portfolio value from the volatility of individual asset values requires estimates of correlation in credit quality changes. Since these cannot be directly observed from historical data, one approach is to infer these from historical asset correlation data derived from equity price series. Several different approaches, including a simple constant correlation, can be used.
The dimensions of Risk Capacity™ can be broken down into five categories defined as follows.
10.2.1 Five Dimensions of Risk Capacity™
Dimension 1: Time Horizon and Liquidity Needs
The Time Horizon and Liquidity Needs dimension estimates how rapidly investors may need to withdraw money from their investments. A low score indicates that an investor may need money in less than two years. A higher score indicates that an investor may not need to withdraw money for ten years or more. The longer an investor holds onto a risky asset with at least a twenty year record of associated returns, the less chance there is of obtaining a poor cumulative return. The time series graph will show you the importance of time horizon and how it relates to risk and return. Select different time periods and see how it affects the distribution of returns.
Dimension 2: Attitude Toward Risk
The Attitude Toward Risk dimension estimates aversion or attraction to risk. Risk is defined as "the possibility of loss," and this category addresses the ability to stomach the inevitable decline of any investment subject to risk. If it never declines, there is no risk and therefore no reason for the investment to earn a return. High returns are not available without accepting high risk. A high score suggests a capacity of tolerating high risk investing to obtain the potential for higher returns. A low score indicates a risk aversion and the need to invest more conservatively. High risk attitudes are derived from individual personality, experience, gaming inclination, or a number of other factors. Of all the Risk Capacity™ dimensions, this is the most difficult to quantify, as it is an intangible quality. Figure 10-2 shows the relationship between risk attitude, time horizon, and optimal portfolios.
Figure 10-2
Dimension 3: Net Worth
The Net Worth dimension estimates capacity to take various levels of risk with investments. A high net worth provides a cushion for the uncertainty of future cash needs. Because life is a random walk, we are never certain of tomorrow’s requirements. The more assets there are in reserve, the higher one’s capacity is for risk. The higher the net worth, the higher the capacity for risk. (net worth calculator from dinkytown.net )
Also see (right click on link, then save target as, save to your Desktop) the Financial Summary and Planning Spreadsheet for both net worth and income statement creation and analysis. Call an Index Funds Advisor to assist you in filling it out: 888-643-313.
Dimension 4: Income and Savings Rate
The Income and Savings Rate dimension estimates excess income and ability to add to savings. A high score indicates that a large percentage of income is discretionary and is available for investing. A low score indicates that all or almost all income is being used for ordinary expenses and not being added to annual investments. A higher income also adds to the cushion for surprise or emergency cash requirements. net income calculator Figure 10-3 shows the relationship between net worth, net income, and optimal portfolios. For a detailed analysis of retirement planning, see netirement.com.
Figure10-3
Dimension 5: Investment Knowledge
The Investment Knowledge dimension estimates an investor’s understanding of the 12-Step Program to Index Funds. A high score indicates a good understanding of Modern Portfolio Theory and the failure of active management. A low score indicates that a review of this 12-Step Program may be needed. See Figure 10-4.
Figure 10-4
How important is investment knowledge? A recent study of 401k plans highlighted the Causes of Low Returns for 401k Plan Participants:
"The low returns also reflect a number of inherent failings in 401(k) plans as currently structured, involving participants, plan sponsors and the law.
Problem: Lack of Knowledge.
Several studies find that many participants in defined contribution plans have an appalling lack of understanding of basic principles of investing. For example, a recent national survey of participants found:
1. Respondents generally considered company stock less risky than a diversified domestic equity portfolio.
2. 44 percent thought money market funds included stocks and 43
percent thought they also included bonds.
3. Nearly 20 percent didn.t know they could lose money in equities.
4. 65 percent didn.t know they could lose money in a bond fund and 60 percent didn't know they could lose money in a government bond fund.
Small wonder that so many participants in 401(k) plans have little or no grasp of the principles of prudent investing! They may have a limited or extensive list of funds from which to choose, but they base their selection on individual funds rather than investment strategy. The fund offerings may not stress the value of index funds, which invest in the stocks or bonds used to compute a particular index and have low management fees because they are not actively managed. Participants take too little risk, as in the case of those letting most of their assets stay in money market funds or cash, or too much risk, as in the case of those putting the great majority of their assets into high-tech stocks or funds. Many participants have an appalling lack of understanding of basic principles of investing." (Source: Reinventing Retirement Income in America by Brooks Hamilton and Scott Burns, NCPA Policy Report No. 248December 2001
Your investment returns are 100% explained by Risk Capacity™, because your capacity directs you to your proper risk exposure, also referred to as your asset allocation or investment policy. The result of a careful analysis of your Risk Capacity™ is a risk exposure that you can hold on to through thick and thin, or the ups and downs of the market. This minimizes transaction costs and optimizes long-term returns. When your Risk Capacity™ and your Risk Exposure are aligned, your returns are optimized .
10.3 Problems
10.3.1 Investors Do Not Properly Assess Risk Capacity™
The problem many investors face is the improper measurement of their Risk Capacity™. Each dimension has to be carefully examined and then quantified. Finally, some dimensions are more important than others, so they must carry more weight in the determination of a final score. As in any survey, the questions must be carefully designed, and the investor must be totally honest and accurate.
10.3.2 Risk Capacity™ Changes Over Time
The second problem investors face is that their Risk Capacity™ changes with time and circumstances, and they fail to recalibrate their capacity on an annual basis. Just as a portfolio needs rebalancing to maintain consistent risk exposure, the dimensions of Risk Capacity™ need to be remeasured to maintain a consistent Risk Capacity™ that matches the changing circumstances.
10.4 Solutions
10.4.1 The Risk Capacity™ Survey
The five dimensions of Risk Capacity™ are measured through a Risk Capacity™ survey that poses several questions to the investor. This survey is the single most important step of the investment planning process. Index Funds Advisors offers three surveys on their website at www.ifa.com. The complete survey includes forty-nine questions, the 401(k) survey has nineteen questions, and the quick survey is comprised of five questions. Based on the answers from the two longer surveys, a thorough analysis is generated. The quick survey is designed to provide an overview of the five dimensions and should not be relied on for determining asset allocation, unless the answers are discussed with an investment advisor. The quick survey asks the following five questions.
1. Assume your investments do not increase in value. Within how many years do you plan to withdraw more than 20% of all your investments?
a. less than 2 years
b. more than 2 but less than 5 years
c. more than 5 but less than 7 years
d. more than 7 but less than 10 years
e. more than 10 years
2. What is the current value of your long-term investments? Please include your retirement savings plan with your employer and your individual retirement accounts (IRAs.)
a. Less than $25,000
b. $25,000 to $49,999
c. $50,000 to $99,999
d. $100,000 to $249,999
e. $250,000 or more
3. What is your total annual income after the deduction of taxes?
a. Less than $50,000
b. $50,000 to $74,999
c. $75,000 to $99,999
d. $100,000 to $199,999
e. $200,000 or more
4. What is the worst twelve month unrealized percentage loss you would tolerate for your long-term investments?
a. -33%
b. -26%
c. -18%
d. -9.5%
e. Zero; any loss is unacceptable to me
5. How would you rate your knowledge about investing in general and more specifically, the relationship between risk, return, and time?
a. significantly below average
b. below average
c. average
d. above averagee. expert
The total score of a survey is the sum of the scores in each category, each weighted by its estimated contribution to overall capacity. Higher scores point toward higher risk, higher returns, higher volatility, lower-liquidity, and longer-term investments. These would include a larger allocation of Small Capitalization, Value, International and Emerging Market Indexes. A weighted total score of 100 indicates the highest capacity for risk. On the other hand, lower scores would match up to portfolios with lower risk, lower returns, lower volatility and higher liquidity. These would include shorter-term investments such as fixed-income. Take the Risk Capacity Survey here.
