Investing Fundamentals – Risk and Return

June 27, 2014  |  

Investing Fundamentals – Risk and Return

Risk and Return
Tilting your portfolio to gain exposure to stocks with higher expected returns is a sound investment strategy.

risk-and-reward

Key Takeaways

  • In theory, well-established large stocks and high-flying growth stocks would seem to deliver superior returns to investors. Not so.
  • Research shows that over time small stocks and value stocks outperform large cap stocks and growth stocks.
  • For a higher expected return, you need to bear more calculated risk–that means intentionally tilting your portfolio to hold more small stocks and value stocks.

Despite the best efforts of the financial services industry to make investing seem complicated, the basic principles are fairly simple.

Take the notion of risk and reward.

In general, markets reward investors for taking risk. The more risk you take, the greater the (potential) reward you can expect long term. Just note that the words “expect” and “long-term” in the last sentence are not the same as “owed” and “guaranteed.”

Think of the stock market as two axes–one horizontal, the other vertical (see below)

 

risk and return investing

 

At the top of the vertical axis you have the smallest companies and at the bottom, the largest companies. On the left side of the horizontal axis are what we call growth stocks. These companies have a healthy cash flow and their revenues and earnings are expected to grow at a higher-than-average rate.

On the right side of the horizontal axis we have “value stocks” which trade at a lower price relative to common valuation metrics, such as dividends. For whatever reason, these companies are out of favor in today’s market and could be considered undervalued.

Large stocks are considered less risky than small stocks. And growth stocks are considered less risky than value stocks.

But, here’s the thing. Research shows that over time, its generally small stocks and value stocks that deliver superior returns to investors.

Not convinced? Look at stock market returns going back to 1926 and divide the next 75 years into three periods of 25 years each (see chart below). You’ll see that value stocks outperformed growth stocks in all three 25-year periods. And they’ve done it again in the 12-year period since 2001. 

You’ll also see that 88 percent of the time since 1926, small stocks have produced higher returns than large ones. At first, that might sound counter-intuitive. But both it make economic sense.

 

Value and Small2

 

Why small cap and value lead the way
The smaller a company is (based on market capitalization), or the more out-of-favor it is, the more it HAS to deliver a higher return to investors in order to compete for their capital. So, think of the point where the axes intersect as your average stock. This kind of stock comes with an average risk and an average expected return (see chart below).

 

Best Over Time2

 

You can capture an average return–simply and inexpensively–by investing in the entire market, via a broad-based index fund such as the Vanguard Total Stock Market Index.

But, for a higher expected return, you need to bear more risk. And that means investing the northeast quadrant (see above)—where you’re exposing yourself to more small stocks, more value stocks, or both.

We call that tilting your portfolio.

Conclusion

Successful investing will never be effortless and stress-free. But you can sleep better at night by having a well thought out game plan and sticking to it. In addition to having piece of mind, you can tilt, not wilt, your portfolio whenever times get tough or great opportunities arise.

A trusted advisor can be a great help in regularly reviewing your plan and coaching you toward your lifelong goals. We’d love to start a conversation with you.

Feel free to contact me (610-695-8070) any time if you’re unsure about your asset allocation or long-term financial objectives. We have plenty of information about these and other topics in the Free Resources section of our website. Also check out our new free white paper The Anesthesiologists Guide to Investment Risk and Reward. You don’t have to be a medical specialist to take advantage of the recommendations and insights we share.


About Chas Boinske

Charles P. Boinske, CFA, is a 30 year investment management veteran overseeing the strategic direction and portfolio management process for Independence Advisors, LLC. Have a question for Charles? CLICK HERE TO ASK CHARLES
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