Wednesday, March 12, 2008

Five risk factors form the basis of investment returns.

From DFA Canada:

Evidence from practising investors and academics alike points to an undeniable conclusion: Returns come from risk. Gain is rarely accomplished without taking a chance, but not all risks carry a reliable reward. Financial science over the last fifty years has brought us to a powerful understanding of the risks that are worth taking and the risks that are not.

Three Equity Factors

1) Market
Stocks have higher expected returns than fixed income.

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.

Everything we have learned about expected returns in the equity markets can be summarized in three dimensions. The first is that stocks are riskier than bonds and have greater expected returns. Relative performance among stocks is largely driven by the two other dimensions: small/large and value/growth. Many economists believe small cap and value stocks outperform because the market rationally discounts their prices to reflect underlying risk. The lower prices give investors greater upside as compensation for bearing this risk.

Size and Value Matter

In US dollars. Developed markets value and growth index data provided by Fama/French. The S&P data are provided by Standard & Poor's Index Services Group. US Small Cap Index is the CRSP 6-10 Index. CRSP data provided by the Center for Research in Security Prices, University of Chicago. International Small Cap index data: 1970-June 1981, 50% UK small cap stocks provided by the London Business School and 50% Japan small cap stocks provided by Nomura Securities; July 1981-present: simulated by Dimensional from StyleResearch securities data; includes securities of MSCI EAFE Index countries, market-capitalization weighted, each country capped at 50%. MSCI data copyright MSCI 2005, all rights reserved. Indexes are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Compound returns have an assumed rate of return, are hypothetical, and are not representative of any specific type of investment. Standard deviation is one method of measuring risk and performance, and is presented as an approximation.

Two Fixed Income Factors

1) Maturity
Longer-term instruments are riskier than shorter-term instruments.

2) Default
Instruments of lower credit quality are riskier than instrumentsof higher credit quality.

Dimensional approaches fixed income primarily as a strategy to maximize overall portfolio benefit. Shorter-term, high-quality debt instruments tend to have less risk. Dimensional engineers lower-risk bond strategies so investors can temper their total portfolio volatility or take more risk in equities, where expected returns are greater.


freako said...

I can totally understand why small cap outperforms large cap (hgiher risk), but if the market was efficient, growth stocks would have higher returns than value stocks, simply because the expected earnings growth is less certain.

mohican said...

Freako - I think the opposite actually holds true. The market believes in the certainty of future earnings of a growth stock (Apple) because of product innovation and proven earnings growth performance. On the other hand it discounts the potential of a value stock (Wells Fargo) because the market participants believe the earnings are at risk or will not grow as quickly.

This is why the Price ratios of a growth stock are high and they are low with a value stock because market participants do not believe in the future earnings of the 'value' company in question.

At issue here is that historically, 'value' does outperform 'growth' and this is well documented.

patriotz said...

If you just categorize a "value" stock by earnings or dividend yield, you get two types.

The first is a stock whose market share and earnings are not expected to grow significantly, e.g. a supermarket chain or a utility. The market prices the stock for a sustainable yield. Low risk.

The second is a stock where future earnings are perceived to be at risk, e.g. cigarette companies. Thus the market prices the stock pessimistically, i.e. at a low P/E.

Lump these together and you can get some anomalous results.

Also perhaps "growth" stocks are more likely to be overpriced during bull markets (the dot-com bubble being the extreme case) and this will affect the average long term total return.

freako said...

Good points.