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High Returns From Low Risk? by Greg Forsythe, CFA, Senior Vice President, Schwab Equity Ratings®, Schwab Center for Financial Research June 1, 2007 Updated from the Summer 2006 issue of On Investing, a magazine for Schwab clients. Perhaps the most basic tenet in investing is that to get higher returns, you usually need to assume more risk. But is there a way to get higher returns and lower risk? The short answer is yes, though not the way you might think. Competitive markets usually prevent any high return/low risk portfolio strategies from lasting very long. Over long periods of time, the basic positive return/risk relationship generally holds true for diversified portfolios within asset classes and diversified portfolios across asset classes. Understanding systematic risk Academic researchers teach that the only type of risk for which investors can expect to be rewarded is called "systematic risk"—the component of portfolio risk that cannot be diversified away. To illustrate, a randomly selected portfolio of 10 stocks will generally have greater overall risk than a randomly selected portfolio of 50 stocks. But since both portfolios have the same systematic risk of being 100% invested in stocks, the expected return of the two portfolios is identical. The smaller portfolio has higher "specific risk," a term describing the portion of portfolio risk contributed by the company-specific risks of each stock holding. But that additional risk cannot be expected to be rewarded because it stems solely from a lack of diversification. While specific risk can be minimized in a carefully constructed portfolio of 30–50 stocks, it can be completely eliminated only by passively investing in all stocks via an index fund or exchange-traded fund (ETF). Performance: actively managed portfolios The usual goal of an actively managed stock portfolio is to outperform the overall stock market. However, it is incorrect to expect any reward for the increased risk incurred by active management. That's because an actively managed portfolio's higher risk relative to a market benchmark is generally only specific risk—not the type of risk for which we can expect reward. Investment theory does suggest that to earn higher returns one must simply own a portfolio with above-average systematic risk. Using beta to quantify risk In the 1970s, academics developed a measure called "beta" to quantify a stock portfolio's risk relative to the overall equity market, whose beta is set at 1.0. Simply stated, a portfolio with a beta of 1.1 would be 10% riskier than the market, while a portfolio with a beta of 0.9 would be 10% less risky than the market. Furthermore, betas for individual stocks can be calculated and interpreted in the same way. Practitioners have observed over the last 30 years that high beta stock portfolios have not delivered returns above market averages. Puzzled academics have reluctantly accepted that beta alone does not fully capture systematic risk and have begun suggesting that other factors such as company size provide additional explanatory power, but the debate rages on. Measuring performance with Schwab's risk gauge So if neither specific risk nor systematic risk have generally been rewarded, is there any way for the investor to use risk measures to increase portfolio returns? The surprising answer from Schwab's equity research department is "yes." Our research team has developed a "risk gauge" that quantifies the overall risk of each of the approximately 3,000 U.S. stocks we follow. Our gauge measures risk along three dimensions: 1) sensitivity to overall stock market movements, 2) fundamental business risk and 3) vulnerability to investor sentiment changes. We capture these three dimensions by ranking each stock by its beta (high is riskiest), market capitalization (low is riskiest) and consensus five-year forecasted earnings per share (EPS) growth (high is riskiest). The rankings are then equally weighted together to form our risk gauge metric. Measuring Risk The Schwab risk gauge measures the overall risk of approximately 3,000 U.S. stocks along three dimensions.
As of May 29, 2007. Sources: Schwab Equity Ratings, FactSet and the Institutional Brokers' Estimate Service (IBES). Lower risk and higher returns Surprisingly, historically less risk has been associated with more return! Indeed, the 30% of stocks ranked as most risky by our gauge not only have been more volatile than the market, they historically have underperformed the average stock over 60% of the time on an annual buy-and- hold basis from 1986 to 2005. The lesson is that investors seeking higher returns should avoid stocks with high market sensitivity, small size and high EPS growth forecasts. To help you assess a stock's risk, the table above, "Measuring Risk", provides the risk gauge components' current scaling. These cutoff values will likely move up and down a bit in the future. For current Schwab Equity Ratings, clients can log in to Schwab.com:
Important Disclosures This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue any particular investment strategy. Schwab does not assess the suitability or the potential value of any particular investment. Each investor needs to review a security transaction or investment strategy for his or her own particular situation. Although the information contained herein is obtained from sources believed to be reliable, its accuracy or completeness is not guaranteed. Schwab Equity Ratings are assigned to approximately 3,000 of the largest (by market capitalization) U.S. headquartered stocks using a scale of A, B, C, D and F. Schwab's outlook is that A-rated stocks, on average, will strongly outperform and F-rated stocks, on average, will strongly underperform the equities market over the next 12 months. Each of the approximately 3,000 stocks rated in the Schwab Equity Ratings universe is given a score that is derived from several research factors. The assignment of a final Schwab Equity Rating depends on how well a given stock scores on each of the factors and then how that stock stacks up against all other rated stocks. (0607-5969) Return to Top |
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