We believe that investment returns are determined principally by risk, and that a diversified portfolio’s expected return is a result of its exposure to certain market-based risk factors. Since a portfolio’s asset allocation determines its risk factor exposure, how to allocate one’s assets is one of the most important decisions an investor can make. We spend significant time with our clients helping them analyze and create appropriate asset allocation policies, which is largely about selecting an appropriate risk factor exposure.
Our research has identified five risk factors that we believe determine the expected rates of return of a diversified portfolio. The first three are stock market risk factors and the last two are fixed income risk factors:
Market Risk
- Stocks in general have higher expected returns than fixed income securities.
Size Risk
- Small company stocks have higher expected returns than large company stocks.
Valuation Risk
- Lower-priced “value” stocks have higher expected returns than higher-priced “growth” stocks.
Maturity Risk
- Longer-term instruments are riskier than shorter-term instruments.
Default Risk
- Instruments of lower credit quality are riskier than instruments of higher credit quality.
Academic studies show that the degree to which a portfolio is exposed to these five risk factors determines nearly all of its risk and expected return. An advantage of asset class investing is ease with which one can manage risk by investing in precise asset classes.
You can visualize the equity risk components with the illustration below. The extent to which you “tilt” your portfolio toward small and value stocks your increase your risk and expected return.
Cross Section of Expected Stock Returns, Eugene F. Fama and Kenneth R. French, Journal of Finance 47 (1992)
