Investors should expect to be rewarded for providing capital. It makes sense then that if an investor provides capital to a riskier company or government, the investor should expect to receive a higher rate of return. And the evidence confirms this intuition – risk and return are inextricably linked. An investor cannot consistently achieve higher returns without taking greater risk. However, not all risks are the same. Furthermore, not all risks are rewarded.
A widely cited academic framework known as the Fama/French Three Factor Model demonstrates through empirical evidence that there are 3 risk characteristics of stocks that are rewarded over long periods of time:
|1.||MARKET||Stocks have higher expected returns than bonds
|2.||SIZE||Small company stocks have higher expected returns than large company stocks
|3.||PRICE||Lower priced “value” stocks have higher expected returns than higher priced “growth” stocks|
The market factor is familiar to most investors: stocks have a higher expected return than bonds. Why? Because stocks are riskier than bonds.
Next is the size factor. Why should small company stocks have a higher expected return than large company stocks? Many economists believe this is because the market discounts their prices to reflect their underlying risk. Smaller companies are riskier than larger companies.
Finally, the third factor is price: lower priced "value" stocks often represent out-of-favor companies that may be facing financial distress or general business difficulty. Like small company stocks, value stocks have a higher expected return because the market discounts their prices to reflect their risk.
Empirical studies show that the degree to which a portfolio is exposed to these three risk factors (market, small company stocks, and value stocks) explains over 95% of its risk and expected return.1
1Dimensional Fund Advisors study (2002) of 44 institutional equity pension plans with $452 billion total assets. Factor analysis run over various time periods, averaging nine years. Total assets based on total plan dollar amounts as of year end 2001. Average explanatory power (R2) is for the Fama/French equity benchmark universe.