Risk on investments can be measured, claim the experts, enabling us to identify which risks have tended to deliver the rewards. Dave Bradfield explains how this is done
Last year’s crash on the Johannesburg Stock Exchange (JSE) highlighted once more that the additional returns investors seek on the JSE (over and above the promise of a safe fixed income investment), are not without risk. Consequently, many investors have been reminded that the seemingly intangible notion of risk is a very real consideration, affecting not only the “other” guy and portfolio managers, but also ourselves.
Another important reason for considering the risks of investments is not to put the fear of God into individual investors, but rather because we now have strong evidence about the types of risks that are worth taking. In other words, it seems that we are able to identify which risks have tended to deliver the rewards.
Risk, to many, reflects the degree of uneasiness that is felt when faced with uncertainty. But how are individuals able to take account of this slippery notion of risk in their investment decision making? The answer is in the same way as professional portfolio managers do. Most of them buy into the idea that risk can easily be measured, ultimately giving rise to decisions based on objective quantitative information, rather than on the abstract feeling of “uneasiness”. Although individual investors are unlikely to physically measure these risks, they can nevertheless do some “quick and dirty” assessments of the risks they bear.
The important and useful ideas on “risk” are simple ones, and free from any mathematical complexity – they are well within the grasp of individual investor “hobbyists”.
The degree to which the value of financial assets “bounce” around is termed the “volatility” and is widely interpreted as the “total risk” of the financial asset (it is measured by the statistical measure of the variance of returns). This is where a deeper appreciation for risk becomes interesting. It is widely known among keen followers of stock markets that the volatility of individual stocks is driven by two sources. The first source is the inescapable risk of movements of the market as a whole, aptly termed market risk. A stock market crash, for example, affects all stocks in the stock market. Few stocks can escape market crashes, such as the August crash precipitated by the Asian crisis.
The second source of risk captures the movement of investments that is unrelated to movements of the market. This component of risk concerns the perils that pertain specifically to individual companies, and is named unique risk. Fortunately this component of risk diminishes rapidly as one adds more stocks to a portfolio. Bad news befalling one company is often offset by “good news” of another. This “cancelling out” effect is intuitive and is precisely why investors have diversified through the ages. Interestingly, research reveals that even if we randomly select stocks, as few as 15 stocks in a portfolio knocks out a major portion of the unique risk of our investment. Adding more stocks to a portfolio thereafter has a very small impact on reducing unique risk further.
We have pointed out that diversification reduces unique risk, but that market risk is inescapable. It is, however, worth pointing out that although market risk is inescapable, we can reduce (or cushion) our exposure to it.
The well-known measure of market exposure of an investment is termed the beta coefficient, which captures the sensitivity of investments to movements of the market index. If an investment is expected to move in tandem with the market index it would have a beta of one. A share with a beta coefficient greater than one is expected to rise more than the market index on an upturn, and to fall more than the index in a declining market – it is more volatile.
By contrast, an investment with a beta less than one is expected to rise less on a market upturn and to fall less than the market index in a downturn. Managers or investors who believe they have skills at predicting market movements will want to shift the beta of their investment around to take advantage of these movements. Shifting the investment beta upwards in market upturns and reducing the investment beta in market downturns is the ideal scenario.
In establishing what lessons individual investors can learn from the large professionally managed portfolios, we have turned to the historical performance analysis of the unit trust industry for some clues (simply because a reliable track record of available performance data is publicly available).
Our analysis of general equity funds over the last five year period has yielded some clues. The most important is that the poorly performing funds typically had betas that were lower than the average of their peers, and above average performers typically had above-average beta’s. This evidence clinches the link between “market risk” and performance.
On searching for clues on whether bearing unique risk seems worthwhile – we found none. Is this finding consistent with finance theory? The answer is yes. Academics argue that because unique risk can be diversified away without additional cost (it costs no more to put all funds into many stocks rather than only one) there is no reason why investors should expect to be compensated for bearing risk that can be avoided without cost. Consequently they argue that only unavoidable risk, that is market risk, bears compensation.
So it seems that market risk is the important component of risk that warrants deeper consideration. But how can all of this help individual investors?
The first lesson is that a fixed interest investment of cash (at a bank, for example) is risk-free and therefore has a beta of zero. If one, for example, increases the cash component in one’s portfolio, the portfolio beta declines accordingly and vice versa. For example, if investors decided to liquidate half the value of their stock portfolio and to invest the proceeds in cash, the beta of the portfolio would immediately halve. Such a strategy would be sensible if investors were concerned about a potential market downturn.
It is interesting to note that the average beta of the general equity category of unit trusts turns out to be 0,85. This figure suggests that, on average, fund managers have about 15% of the portfolio in cash and the remaining 85% in a diversification of stocks. Individual investors hoping to outperform unit trusts should bear in mind that they typically have other low beta investments (such as their property, annuities, and so forth). On balance, the impact of these additional low beta investments suggests that they needn’t invest in cash if they are attempting to hold at least the same market exposure as the unit trust industry.
One advantage individual investors have over the unit trust industry is that they don’t get monitored routinely like fund managers. Hence they can afford to look for rewards over the longer term. Our evidence that high beta investments have been superior over the longer term is indeed compelling for the individual investor. It clearly suggests that individuals with longer-term investment horizons should not be afraid to raise the beta of their investment. If you want to do well in the game, you have to play. Clearly there are no rewards without taking risk – and the risk that can be expected to pay off is market risk as measured by the beta coefficient.
By contrast, the risk that investors should not expect to be compensated for – unique risk – is, in essence, the risk of holding an undiversified portfolio. In other words, betting large proportions of your wealth on one or two stocks only is a risk that does not appear to pay off.
Dave Bradfield heads the quantitative research division of the Cadiz Group. He is a former professor at the University of Cape Town’s department of statistical sciences and is an associate editor of the Multinational Finance Journal