Managing Good and Bad Investment Risks

Perhaps the most critical concept in investing is the relationship of risk and expected returns.

Successful investors constantly consider this relationship because risk and return are inextricably linked. To get higher returns, investors must take higher risk. However, all risks aren’t created equal.

Good risks are associated with positive expected returns, while bad risks are those that carry an extremely low likelihood of positive returns.

By distinguishing between the two and understanding the market dynamics of risk, you can significantly improve returns.

Bad risk

Academic research over the past 50 years has shown that one type of bad risk is market timing—darting in and out of the market or changing holdings abruptly based on predictions of upticks and downticks. As the market is a mercurial creature whose movements can’t be predicted with any precision, this is a good way to go broke. The evidence is clear: few if any investors have been able to harvest excess returns from market timing in a sustainable manner. This is why you should avoid market timing.

The research also shows that risk from stock-picking—buying and selling stocks in what’s known as an actively managed portfolio—is another bad risk. Though some professional investors can do well at this for a time, their luck eventually runs out. The research is also clear on this point: It’s difficult to consistently beat the market because no one is consistently smarter than the market—­all known information is already priced into stocks.

Good risk

Investors are far better off using passive management—funds that give low-cost exposure to good risks instead of having fund managers buy and sell stocks, as they do in expensive actively managed mutual funds and individually managed stock portfolios. Passively managed funds can help investors avoid the error-prone practice of trying to predict which stocks will go up or down.

Investing this way involves a good risk called market risk: the risk that the market will rise and fall over time as economic conditions change. Sometimes the declines are extreme, as they were in 2008. Yet, by properly structuring and maintaining well-diversified portfolios as part of a good long-term plan, investors can withstand such meltdowns and do well on average over time. (These stock portfolios should be part of broader portfolios that include other asset classes, including bonds.)

Business cycle

The higher returns investors expect for taking more risk are known as the risk premium. To get this premium, you must understand the market relationship between risk and expected return.

Let’s say you want to increase your level of market investment but, as the economy is in recession at the time, you decide to wait because you think the market is too risky. This would be a mistake. Expected returns are actually higher for investments made during the down part of what’s known as the business cycle—the economy’s perpetual expansion (rise) and contraction (fall).

As perceived risks are reflected in stock prices, the more risk seen during a down cycle, engendered by falling earnings, the lower stock prices tend to go. This happened during the recession in 2008. During such periods, expected returns increase because there is more room for share price growth when stocks are starting from a lower point. By definition, price and expected return are inversely related: lower prices mean higher expected return.

As the business cycle turns upward, investors tend to accept lower expected returns because, as earnings improve and competition spurs prices relative to performance, the market sees stocks as less risky. Currently, with the business cycle having since turned upward and a go-go market having been in effect all last year, perceived risk and expected returns are lower.

Economic conditions can only be known in hindsight, and stock prices reflect the market’s view of the future course of the business cycle. As new information becomes available, stock prices adjust to provide investors with expected return in line with perceived risk.

So, if you wait for a weak economy to improve to invest, you could be missing out on significant returns. This isn’t to say investing in a good economy isn’t a good idea. During these periods, you may expect lower returns, but you can take comfort in the lower risk you take to get them.

Moreover, understanding the risk/expected return dynamic can provide a “reasonableness detector” to evaluate investment offers you’ll get during the upward part of the business cycle—those that purportedly involve low risk and high expected returns. Understanding risk keeps you disciplined in up markets, when many investors surrender to the siren call of greed, and overpay. And in declining markets, this understanding can inoculate you against contagions of fear so you don’t sell low in a panic. Instead, you can take advantage of the risk premium.

Diversification and long-term planning

You may not want to invest much differently in one type of economy or market versus another. The idea is to have an investment plan and stick to it to get the long-term average returns that the market will give you if you let it, through up cycles and down. Instead of changing horses, this means staying with those that are taking you steadily to your destination. This horse team is your diversified investment plan.

Regarding stocks, this plan should include passively managed exposure to companies of different sizes from different industries. If the widget companies you own happen to founder, for example, you have other types of companies, not affected by the same forces, to buoy your portfolio.

While diversification among different types of companies is important, in the pursuit of higher expected returns there are two types of companies that you might want to weight more heavily than others in your portfolio: small stocks and value stocks. Focusing on such companies has historically carried acceptable risk because they have long outperformed large companies by remarkable margins. The performances of these two types of stocks between January 1926 and December 2012 are astonishing.

During this period, small stocks outperformed large ones in 622 of 865 rolling 15-year time periods, 658 of 805 rolling 20-year periods, 629 of 685 rolling 30-year periods and all 565 of 565 rolling 40-year periods.

During the same period, value stocks (those whose prices are depressed because they are financially distressed, if only from being new companies) outperformed large company stocks in 775 of 859 rolling 15-year periods, 766 of 799 rolling 20-year periods, all 679 of 679 rolling 30-year periods and all 559 of 559 rolling 40-year periods.

The reason for this outperformance of these categories in the aggregate is the risk premium — investors’ reward for taking more risk. If you are a bank and a small or financially distressed company comes to you for a loan, you’re likely to charge them more interest than you would a large, financially sound company. So the expected return on these loans is higher. The same goes in the stock market. Because risk is perceived to be higher for these companies than for large ones, overall expected returns are higher.

You can manage risk

So investors can do well if, like a judicious loan officer, they can manage risk by picking the right companies to invest in. But, as you don’t want to take the unacceptable risk of stock picking, you should buy not a few but potentially hundreds of them through index funds. This spreads out risk, positioning you to get the average risk premium of all of these stocks.

The key to long-term success in the stock market is to avoid the risks that carry no expected payoff and embrace those that do. By understanding the difference, and by applying this knowledge to a well-diversified, passively managed stock portfolio, you can harvest the aggregate risk premium without actually taking much risk.

Charles P. Boinske (cboinske@independenceadvisors.com) is president of Independence Advisors LLC, and has been a financial advisor serving individual investors for 25 years. A Chartered Financial Analyst, Boinske has been a featured speaker at national and international industry conferences and is a member of the New York Society of Security Analysts. He received a B.S. in economics from Penn State University.