Taking Risks That Make Sense
Risk is one of those things that everyone talks about in investing, but no one truly understands. This is, in part, because it means something different to everyone. What I consider a big risk, you may consider inconsequential. But we can agree on this rule: More risk does not mean more return, but more return follows more risk.
In our last article, we looked at what diversification means and taking risks that make sense while avoiding risks that don’t. This time, we’re covering the many forms of investment risk.
There are two categories of risk: systematic and unsystematic. Read my previous post for a thorough exploration of unsystematic risk, but in simple terms, it is any risk specific to a single company (or small subsection of the market) — their CEO getting hit by a bus or a product catching fire — and can be eliminated through diversification.
Systematic risk, our focus here, is more pervasive. We want to focus on the systematic risks with positive expected returns. In other words, we want to take the risks that the market pays us to take.
Several types of risk fall under the umbrella of systematic risk, some of which are good and some of which are bad. There are a few criteria that we use to separate the wheat from the chaff. We want to see risk factors that have a positive expected return that we can see through time and across different markets, a characteristic of stocks known as “persistence.” We know that these risk factors won’t have positive results every year — there wouldn’t be any risk if it happened every year. Persistence simply means that we see a positive pattern over time and across different markets.
So what risks do we want to work with?
On the bond side, they’re pretty straightforward, and most people already focus on them: maturity and credit risk.
MATURITY RISK – (a.k.a. term risk) This is based on how long a company or government is borrowing money. The longer you borrow money, the higher the interest rate you need to pay.
CREDIT RISK – The risk that you won’t receive the payments that you’ve been promised. If people are worried you won’t pay them back, you need to pay more in interest.
On the equity side, things get a little more abstract. Four equity risk factors exist that we want to work with: market, size, value, and profitability risk.
MARKET RISK – Market risk identifies that stocks are riskier than bonds. Bonds come with promised fixed cash flows. With stocks, that’s not the case — investors are buying a very tiny ownership stake in a company. As a “business owner,” the success or failure of your stock depends on how the company does, as well as how the company does relative to the market’s expectations. This comes with a lot of uncertainty, and for investors to take that on, there needs to be a lot of upside. The upside comes in the form of a low price with room for the stock to go up and create a positive return for holding the stock.
SIZE RISK – A good way to think about size risk is in terms of a bank giving out loans. If two companies go to a bank for a loan, the larger company is generally going to have to pay less – they’re bigger so there’s less chance they will go out of business or not be able to pay the bank back. It’s the same principle here. Smaller companies tend to be more unstable — there’s less certainty about their cash flows. Investors will take on that uncertainty, but only with the promise of higher returns.
VALUE AND PROFITABILITY RISK – The next two risks, value and profitability, are easiest to talk about together. You can think of these as price risk factors. Value risk says that a company with a lower market value (the total value of the company’s shares) relative to its book value (what the accountants say the company is worth), should have a higher expected return. The market doesn’t like them for some reason, so investors demand a higher return for the risk they’re taking. The same thing is going on with the profitability risk factor. If a company has a low market value relative to their profitability, it means that the market does not like them for some reason. Again, investors want a higher return for sticking their necks out.
There are nuances and gradations to all of these risk factors, but these are the building blocks to creating the best portfolio that you can. By focusing on these risk factors, you can create the portfolio that gets you the highest possible return, with the lowest possible risk.