Every investment choice you make involves a trade-off between risk and return. In general, a portfolio of safer investments will have less growth potential than a riskier one. To increase the rate of return, you typically have to take more risk.
If your rate of return objective is higher than permitted by your time horizon and risk attitude, you must adjust one of the three parameters.
Over the course of your investment life, the value of your portfolio will rise and fall. We would always rather see our portfolio value rise but a prudent investor knows that any investment will have some periods in which the value will fall.
Your risk tolerance describes your level of comfort waiting through the downturns. If the risk you take is within your risk tolerance, then you will be able to maintain your investment strategy both through strong markets and weak ones, giving you the best chance of success.
One way to construct a rate of return objective is to find the portfolio that offers the highest possible rate of return objective for your time horizon and risk attitude. This is known as an efficient portfolio.
The first piece of economic theory to investigate the link between risk and return is the capital assets’ pricing model. This determines a theoretically appropriate required rate of return of an asset, if it is to be added to an already well diversified portfolio. The model takes into account the asset’s sensitivity to non-diversifiable risk (also known as systemic risk or market risk), often represented by the quantity beta, as well as the expected return of the market and the expected return of a theoretical risk-free asset.
The risk of a portfolio comprises systematic risk, also known as undiversifiable risk, and unsystematic risk, also known as idiosyncratic risk or diversifiable risk. Systematic risk refers to market risk. Unsystematic risk is the risk associated with individual assets. Unsystematic risk can be diversified away to smaller levels by including a greater number of assets in the portfolio. The same is not possible for systematic risk within one market.
Depending on the market, a portfolio of around 30 to 40 securities in developed markets such as the UK or the US will render the portfolio sufficiently diversified to limit exposure to systemic risk only.
In developing markets, a bigger number is required, due to higher asset volatilities.
A rational investor should not take on any diversifiable risk, as only non-diversifiable risks are rewarded within the scope of this model. Therefore, the required return on an asset, that is, the return that compensates for risk taken, must be linked to its riskiness in a portfolio context – its contribution to overall portfolio riskiness – as opposed to its stand-alone riskiness.
In the CAPM context, portfolio risk is represented by higher variance, that is, less predictability. In other words, the beta of the portfolio is the defining factor in rewarding the systematic exposure taken by an investor.
The early work on CAPM has been developed and now says three factors, taken together, explain a large amount of the common variation in stock returns, along with the differences in average returns related to risk. These three factors are market, company size and book-to-market ratio.
Modern portfolio theory tells us we can build diversified portfolios to greatly reduce stock-specific risk but even a diversified portfolio is subject to the overall movements of the market.
Fortunately, the theory predicts that the market will reward us for taking this risk by giving generous long-term growth potential. The asset allocation decision is where we decide how aggressively to pursue this long-term growth.
Patrick Murphy is director of wealth management at Thinc