By Jack Forehand (@practicalquant) —
Investing can seem incredibly complex at times. With the rise of complicated computer-based strategies, more and more factors being discovered every day, and even more advanced techniques like machine learning rising to prominence, it can feel like investing is something that shouldn’t be attempted without a PhD. But underneath all that complexity are some very simple facts that have always held true historically and will continue to regardless of how complex the investing world gets.
Perhaps the most important of those facts is also the simplest – there is a direct correlation between return and risk.
If you invest in a T-Bill, you expect a fairly low return, but you also can have a high level of confidence that your money will still be there when you need it. If you invest in stocks, you can be much less certain of that, but you will likely get a far better long-term return.
The relationship between risk and return, although not perfect, is one of the true immutable laws of investing. This relationship can sometimes be deceiving, though. The reason is that not all risks are compensated with additional return. Some risks offer no benefit at a significant cost. One of the keys to investing is to avoid these risks at all costs. The risks that you do get compensated for are hard enough to endure. Adding unnecessary risk to them is a recipe for inferior long-term returns.
To illustrate this, I wanted to take a look at a few uncompensated risks that investors often take and how they can be reduced or eliminated. This is by no means an all-encompassing list, but I hope it provides an idea of the things that can add risk to a portfolio without the commensurate increase in potential returns.
1 – Overconcentration
I am a big believer in concentrated investing. For those who can handle the volatility, the evidence is strong that increased exposure to your best ideas can lead to additional return over time. In other words, concentration is typically a risk you get additional compensation for. But it is also a double-edged sword. Investment theory shows that you can achieve most of the benefits of diversification at 20-25stocks. At levels below that, you begin to take risk that you aren’t compensated for.
Overconfidence leads us all to believe that we will be right when we pick a stock. The facts show that even the best investors are wrong much of the time, and sometimes we can be really wrong. Those types of mistakes can blow up an overconcentrated portfolio, while a more diversified portfolio would have been able to live to fight another day. There is also a behavioral aspect to this. The more volatile an investor’s portfolio is, the more chance they have to make bad decisions as a result of that volatility. Diversification is often referred to as the only free lunch in investing. Taking advantage of it will help to reduce uncompensated risk.
2 – Trying to Pick Specific Metrics Within Factor Investing
There are a lot of ways to define value. The academic studies have typically favored the Price/Book ratio, but practitioners use a much wider variety of metrics from the PE ratio to the Price/Sales ratio to more advanced metrics like Enterprise Value/EBITDA. There is a case to be made for why each of these metrics is better than the others, and why it is inferior. For example, the PE Ratio is supported by many because it measures a company’s value against its profits, which makes intuitive sense. But profits are an accounting metric and are subject to manipulation, so others prefer to use Price/Cash Flow instead. Many academics favor the Price/Book ratio, but in a world where many firms’ biggest assets are intangible and don’t even show up on their books (see this article by O’Shaughnesssy Asset Management), there are serious flaws in it. You could go on and on picking apart every valuation ratio if you wanted to and could eventually land on the one you think is best. The question, though, is why bother?
The pain of value investing is hard enough to endure on its own, as anyone who has invested in value stocks over the past decade knows all too well. Why add to that by trying to figure out the specific value factor that will work best? If you try to do it, you may get lucky, and there are likely a select few within the professional community that have the skill to do it, but those who try are more likely to just take on additional risk, with no reward to show for it.
A perfect example of this is the plight of the Price/Book ratio over the past decade. Not only have the majority of academic studies that have looked at the outperformance of value over time used Price/Book, but the major indexes and the largest value shops like DFA also rely heavily on it. Going into the most recent decade, it would have seemed logical to conclude that if I was going to use a value strategy, Price/Book could be the metric to use. The problem is that Price/Book has lagged all the other value metrics by a wide margin since then. The pain that is typically associated with value investing has been much worse for investors who invested primarily with the Price/Book.
So how do you avoid this risk? The answer is pretty simple – just use a composite of all the major value factors or invest in a fund that does so. By doing that, you can make sure you are making a pure bet on value in general without the added risk that whatever metric you select ends up being the wrong one.
3 – Rebalancing at the Same Time Every Year
This is a less obvious risk than the other ones and is likely not as big, but it still is an unnecessary risk that you are unlikely to be compensated for. Many investors choose to rebalance their portfolios on a specific date every year. This is true for investors who use asset allocation strategies and adjust their weighting of stocks and bonds as well as investors who change the stocks within their portfolio.
The problem with this approach is there is a risk that temporary market conditions on the date that is chosen can lead to less than optimal results. For example, if you rebalance a value screen on a specific date, it could lead to a large move into a specific sector when that sector is exhibiting the characteristics of a value trap.
The problem can be the most pronounced for those who follow trend following strategies. Since trend following strategies will sell if the market is below a specific moving average, and stocks tend to bounce above and below them at times, the date you pick can be the difference between being in or out of the market for an extended period of time. This can lead to significant differences in results.
Behavior also plays a big role in increasing this risk. If you experience a significant negative performance event as a result of rebalancing at the wrong time, you are more likely to abandon your investment approach. This can greatly magnify the negative consequences for long-term returns.
The good news is that this risk is also a simple one to eliminate. By rebalancing a portion of your portfolio on more frequent dates, you can reduce or eliminate it without adding to turnover. For example, if you reallocate your portfolio among asset classes once per year, you could instead rebalance 25% of it every quarter. Or if you follow a trend following strategy where you make the decision to be in or out of the market at month end, you could do 25% of your portfolio weekly. In both cases, you aren’t increasing your turnover. You are just spreading the same turnover over multiple periods to limit the chance that luck will have an adverse effect on your returns.
For a much more detailed look at this issue, check out this great article by Corey Hoffstein at Newfound Research.
If You Take Risk, Get Paid for It
Investing is difficult enough as it is. Unless you are well ahead of the game in terms of your savings, generating the long-term returns you require is likely to require taking a level of risk that will lead you to be uncomfortable at times. Given all the risks that are unavoidable in investing, there is no need to add to them by taking risks that don’t offer any rewards. Taking a periodic look at the risks you are taking and making sure that you are likely to be compensated for them is a great way to increase the odds of achieving your investing goals.
Photo: Copyright: dirkercken/ 123RF Stock Photo
Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.