Are You Getting Paid for the Risks You’re Taking?
Even when most stocks are rising, some do better than others, and some are riskier than others. Make sure you earn what you deserve for the risk you take.
Our economy is based on the idea that investors get compensated for taking risks. That’s the idea that funnels capital from investors with a high- risk tolerance to entrepreneurs like Elon Musk or the 1997 version of Jeff Bezos. And it’s why your average retiree, who is understandably risk averse, invests in safer securities, like money markets, despite their lower returns. However, in between, a lot of investors don’t really know whether their riskiest investments are paying their highest returns. In fact, by that measure many investors are getting short-changed on their investments, even if they’re rising in value.
This seems counterintuitive at first. After all, investors have data – yields, returns, credit ratings, and so on – to judge whether they are getting paid appropriately for the risks they take. It’s obvious that junk bonds pay a higher return than investment-grade bonds because of their higher risks. Penny stocks need to have the potential to return more than blue chips because their issuers often have shorter lifespans.
But the top-line numbers obscure pockets of unacknowledged risk. Take the S&P 500 index as an example. Last year, it returned about 18 percent, including reinvested dividends. But most of its returns came from only 10 stocks, five of which were tech giants Amazon, Apple, Microsoft, Facebook and Alphabet. By comparison, the NYSE’s FANG+ index of the 10 biggest tech stocks was up 99 percent last year. If those skyrocketing tech companies were also the riskiest stocks in the index, and the scores of S&P stocks that muddled along at under 5 percent were the safest, then risk is being priced correctly and SPY investors can sleep soundly. But if not, and some of the S&P 500s high-fliers were actually among its safest bets, then investors are not getting in returns what they paid for in risk.
Institutional investors – pensions, insurers, endowments and the like – have a way of analyzing their investments that helps them discover whether they’re getting fleeced in this way. They determine which elements of their portfolio, called factors, drive their returns in a process called “return attribution.” (“Attributing” the return to each factor.) Then they do the same for their risks, in a “risk attribution” exercise. Then they look at the factors that drive their biggest returns and see whether they are the factors with the highest risk. If not, they have an uncomfortable phone call with their asset managers. In fact, since this approach first became popular in about 2000, many smart institutional investors have begun using it to make sure their asset managers aren’t goosing their returns with undisclosed or camouflaged side bets that boost their risk beyond agreed-upon ceilings.
So what are factors? For stocks, these are just the attributes of a company and the behavior of the stock itself – market capitalization, industry, measures of returns and leverage, earnings per share and so on. Many of the financial products offered today aggregate some of these into a style – momentum or growth stock investments are a bet on a company’s performance based on market variables over time, while fundamental or value investment approaches look for undervalued stocks based on their company specific attributes.
Investors can use the stock screening tools on most online brokerage platforms to break down their investments by factors or look them up in databases compiled by Morningstar and similar companies. They can also look at the risk of each stock, often given by online brokers as its beta or volatility. The first is its risk when compared to the market as a whole or an index – low beta stocks move up and down less sharply than the market, while high beta stocks move more. Volatility is simply a measure of how much the stock price moves around its mean. Both higher beta and higher volatility mean higher risk.
Here’s the problem. Beta and volatility measure the risk of a stock, not of its factors. If you have 30 stocks in your portfolio, you might want to know whether you are being appropriately compensated for the risk that comes from any specific factor throughout your portfolio – tech vs banking, large cap vs small, or value vs growth, for example. Just comparing the risks and returns of all your stocks – while certainly a useful thing to do – will not provide this level of insight.
Look again at the S&P 500 example. Say you own one share of each of the 500 stocks. If most of your return came from only 10 stocks, what was it about those 10 stocks? They are all large cap – it is a large-cap index. Five of them are tech (actually six, because Google’s two share classes are in the top 10, and arguably seven if you think Tesla is more tech than auto). Again, this is where you can turn to your stock screener, or research from Standard & Poor’s and other sources that breaks down the index into subcategories, to get a sense of what chunk of your returns are due to their being big and which chunk due to their being tech.
To determine the risk of each factor is a lot harder. Tools that do so often rely on proprietary data and are expensive. For example, Morningstar, which owns Ibbotson Associates, the firm that pioneered factor analysis in the 1970s, offers its Global Risk Model, which does factor return and risk attribution, but it is meant for professional investors. And Googling “risk attribution” turns up a host of articles that quickly become incomprehensible to all but those conversant in stochastic calculus. However, there is a quick-and-dirty way to get an idea about the relative volatility of factors in general, which you can use to get a sense of their risks.
The workaround here is use the risks of factor-specific indices. Various providers offer sector-specific indices (Dow Jones U.S. Bank, Transportation and Utility Indices, NYSE FANG+ Index, etc.), market cap-specific indices (Russell 1000 large cap, Russell 2000 small cap), regional indices (S&P 500 vs FTSE), and so on. Most index providers show volatility data for their indices, which is as a rough proxy for the risk of each factor. For those that do not show volatility, you can calculate – or estimate – it by simply looking at how much the index moves around its mean.
Make sure you use a recognized, authoritative index provider – S&P, NYSE, Russell, FTSE, MSCI or one of the other biggies. These have the important advantages of high-quality data and underlying liquidity. Also, compare like with like. Index providers often publish volatility data in quarterly and annual increments, so pick one to match the time frame you used in your return analysis (stock screeners often use trailing 12-month figures as a default, but they vary).
Finally, make sure you understand correlation. In both rising markets and those that rapidly fall, all factors rise and fall, and factors that seem unrelated can move in lockstep. This is the problem with relying on portfolio diversification as a risk management tool – it works well at all times except when you need it to. However, after a boom or bust, factors once again behave independently of one another, at it is during these normal investment periods that the return and risk attribution methods will prove helpful.
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