Misconceptions about Risk and Return Uncovered
It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so.
Our beliefs about risk and return determine how we construct portfolios and manage risk. Research over the last decade suggests that a number of the ideas on which many investors and advisors rely lead to portfolios that are too highly exposed to market risk. Recent years have vividly demonstrated the perils of such portfolios.
In this article, I will review a number of ideas that determine how we select assets and how we determine what to expect from those assets. I start with the ubiquitous CAPM model and work forward through more recent work. I will then demonstrate how flawed assumptions about available opportunities can handicap portfolio performance, and I will show that rejecting the assumption that investors are not compensated for idiosyncratic risk can be an important way to enhance returns.
As the quote at the introduction of this article suggests, the biggest threat to effective asset allocation is not that we have an incomplete model for understanding risk and return (though we do), but rather that the assumptions we have made about risk and return may be leading us to sub-optimal choices.
Concept 1: The capital asset pricing model (CAPM)
Investors willing to take on more market (systematic) risk will ultimately be rewarded with higher returns, but the (unsystematic) risks specific to individual companies provide no value and thus should be diversified away. That, in a nutshell, is the core foundation of CAPM, the paradigm for portfolio construction that won Bill Sharpe the Nobel Prize in Economics in 1990. Using those two core ideas as a roadmap, we end up with a world view in which the only way to increase portfolio return is to add more market risk. The key idea here is that a single factor determines the risk and return of a portfolio: beta, a measure of market risk.
If CAPM is correct, the only type of risk that investors will be rewarded for taking is market risk. Rational investors will diversify away as much non-market risk as possible (i.e. by holding large numbers of stocks weighted on the basis of market capitalization). The CAPM construct leads directly to the idea that investors are well-served by diversified mutual funds rather than holding a smaller number of individual stocks. Furthermore, the only way to achieve higher returns is to create a portfolio with higher beta than the market.
CAPM also leads to the idea that commodities and gold have very low expected return because the betas of their indexes relative to the S&P 500 are low. CAPM must be substantially modified to rationalize any exposure to commodities.