This is the second in a series of two articles on the relationship between risk and return. The first article in the 2008 Winter Edition of this publication, attempted to define risk and return, and explain how they work together to deliver returns.

This article will look at the difference between good and bad risks, and how to include or exclude these when building an investment portfolio.

By way of a recap, my previous article explained the following important concepts:
• risk is the uncertainty of a future outcome
• risk and return are related, ie one without the other is simply not possible
• higher returns cannot be achieved without taking on higher risk.

Good risks are worth taking, ie risks that have the potential of compensating you with additional return and there has been much research carried out over the years into what constitutes a good risk. The research with the most compelling results was undertaken in the U.S. by two professors; Eugene Fama and Ken French, in the early 90’s. Through systematic testing, Fama and French were able to isolate three main risk factors that provide investors with the potential of obtaining higher returns.

These factors are:
• Market risk
If you are happy to take on the uncertainty of investing in the share market, you have the potential to achieve higher returns than simply by investing in cash.

• Size risk
Smaller companies are more risky investments than larger companies, because there is a greater chance that they may not succeed. If you are happy to take on this increased uncertainty of investing in smaller companies, you have the potential of achieving higher returns than by investing in the safer larger companies.

• Price risk
Companies that are unloved, or have been sold down for some reason (often called value companies), are more risky investments than highly successful companies; once again, because there is a higher chance that they may not succeed. However, if you are happy to accept this higher chance of failure, you have the potential of receiving greater returns than by investing in safer, more successful companies.

Accordingly, if you want to obtain returns in excess of cash in your portfolio, you must be willing to sacrifice the safety of some of your cash, and instead expose it to the uncertainty of the share market.

Furthermore, if you want to obtain returns above the overall market, you must be willing to sacrifice the safety of large and successful companies, and instead expose it to the increased uncertainty of smaller and more unloved companies. This will provide you with the best opportunity of potentially increasing your return (in excess of cash, and also above the market), but you should only do it, if you have the ability to endure the possibility that your portfolio may drop below the initial value invested, over shorter time periods.

Conversely, bad risks are the direct opposite of good risks and don’t necessarily compensate investors for taking them on. Some of the bad risks to avoid include:

• Security selection risk
Where an analyst or investor picks investments based on their predictions on the future price movements of those investments. The problem with this strategy is that it is based on a forecast of the future, and by definition, the future is unpredictable.

Stock picking risks can be minimised by eliminating forecasting from the decision process. In this manner, you wouldn’t try to ‘pick’ only the ‘best’ shares; you would simply buy all the shares available in the market you are looking at. In aggregate, over the long term, there will be more good shares than bad shares and your portfolio will rise with the market.

• Concentration risk (ie only 10 – 30 shares, or only one asset class¹)
There’s a common misconception that a portfolio of around 30 shares provides an adequate spread in a portfolio. However, with around 1,500 listed companies in Australia, only having a portfolio of 30 shares, robs the portfolio of 1,470 other opportunities. What if one of the companies you leave out is the next BHP?

The other misconception is to only have exposure to one asset class (most commonly large blue chip) Australian shares. Similar to share concentration, asset class concentration also deprives the portfolio of other available opportunities. For instance, by only investing in Australian shares, you forego 98 per cent of other listed company investments around the world, as the Australian share market only makes up around 2 per cent of world markets (by size).

The key to avoiding a concentrated portfolio (which is usually an outcome of stock picking) is to diversify; not only within an asset class, but also across asset classes. Accordingly,
a well diversified portfolio should have exposure to around 10,000 separate investments across – large, small and value companies, listed property and cash and fixed interest, both in Australia and globally.

• Timing risk
Refers to the strategy of making investment decisions based on predictions on the future movements of an entire sector, or market. Once again, the issue with this strategy is that analysts are making investment decisions based on making a forecast of the future.  Market timing risks can be minimized by using a buy and hold strategy instead.

This approach to investing establishes a long term asset allocation, which is strictly adhered to through all market cycles, principally because it is exceedingly difficult to try and pick peaks and troughs in various cycles.

Consequently, if you want to avoid the perils of market timing and stock picking, which can lead to a concentrated portfolio, you need to construct a portfolio that is so well diversified that the collapse of one company would only result in you losing, say 1/10,000th of your total portfolio. Importantly, you should have your portfolio diversified across several different asset classes so that your portfolio
is not reliant on just one.

In the lead up to the crash of 2008, there was a significant deviation from the basic risk and return principles and many investors did not understand that in trying to obtain higher and higher returns they were also taking more and more risk, regardless of how it was packaged. It is important to always remember that risk is good, providing that you are both comfortable taking it, and receive an appropriate return for it.

Dirk Dobbs
Manager
ddobbs@moorestephens.com.au

¹ An asset class is a group of securities (eg shares – large, small or value, bonds, cash etc) that display similar characteristics and behave in the same manner