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 pioneered by economists Eugene Fama and Kenneth French demonstrates through empirical evidence that there are characteristics of stocks (factors) that are rewarded over long periods of time:
|MARKET||Stocks have higher long-term expected returns than bonds|
|COMPANY SIZE||Small company stocks have higher long-term expected returns than large company stocks|
|RELATIVE PRICE||Lower priced “value” stocks have higher long-term expected returns than higher priced “growth” stocks|
|PROFITABILITY||Stocks in high profitability companies tend to exhibit a premium vs. those of low profitability companies|
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.
The third factor is price: lower priced “value” stocks often represent out-of-favor companies, some of which may even 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.
A fourth factor is profitability: current profitability contains information about investors’ anticipation of future profitability, and companies with higher future profitability tend to exhibit a return premium than those with lower future profitability.
As much as one may understand in principal that risk and return are related, it is important to emphasize that equities and other risk factors can underperform for stretches of time. In their 2018 paper “Volatility Lessons”, Eugene Fama and Ken French state that “Most of the evidence about the evolution of premium distributions for longer return horizons is good, but there is some bad news. The high volatility of monthly stock returns and premiums means that for the three-year and five-year periods used by many professional investors to evaluate asset allocations, the probabilities that premiums are negative on a purely chance basis are substantial, and they are nontrivial even for ten-year and 20-year periods.” Staying the course through these inevitable periods can be very difficult. Accepting this in advance, and periodically reinforcing on these principles, can enhance one’s chances of success. Preoccupation with shorter-term horizons (even those several years long) can interfere with the best-laid plans.