How to be smarter about risk management

Investors should only take risks that the market rewards--and that they can live with.

Alex Bryan 19 August, 2014 | 6:00PM

In isolation, risk is neither good nor bad. Finance 101 teaches that the market must offer higher expected returns as an asset's probability of declining in value or the potential magnitude of losses increases. Otherwise, given the choice between two investments, no one would hold the riskier one. Investors tend to compete away high-return, low-risk opportunities, so that risk is usually the primary source of investment returns. This is why risky asset classes, such as stocks, have historically offered higher returns than government bonds over the long run. But large drawdowns at inopportune times, coupled with investors' tendency to buy high and sell low, can create a significant challenge for wealth accumulation. Managing risk effectively is one of the most important aspects of successful investing. There are several ways to do this.

The first step is to avoid or eliminate unnecessary sources of risk -- those that the market does not reward. On average, investors should not receive any compensation for risk that they can eliminate through diversification. This was the central insight of the capital asset pricing model, which predicts that assets' sensitivity to market movements (measured by beta) -- a risk that investors cannot diversify -- is the only type of risk that the market rewards. As long as assets are not perfectly correlated, combining them in a portfolio reduces risk relative to the weighted average risk of the individual holdings. Because it is easy to diversify, only an asset's contribution to a diversified portfolio's risk should determine its expected return. While a portfolio's risk is less than the sum of its parts, its return is simply the weighted average of its holdings' returns. Therefore, to the extent that assets are uncorrelated, investors can reduce risk through diversification without sacrificing return.

To illustrate, consider   Lexicon Pharmaceuticals  LXRX, a small-cap U.S. biotech firm that does not currently have any drugs on the market. It has two drugs in the late stages of development that still need approval from the U.S. Food and Drug Administration, without which the company will remain unprofitable. Morningstar equity analyst Karen Andersen estimates that each drug has a 60% chance of receiving approval. This represents a huge risk for investors in that stock. But because the FDA's decisions to approve these drugs would be uncorrelated with the health of the economy or the performance of other companies, investors can virtually eliminate their exposure to this risk by holding this stock in a diversified portfolio. Therefore, the market should not compensate investors for taking it. In the absence of special information, it is good practice to avoid concentrated portfolios.

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About Author

Alex Bryan

Alex Bryan  Alex Bryan, CFA, is director of passive strategies for North America at Morningstar. Before assuming his current role in 2016, he spent four years as an analyst covering equity strategies. He holds an MBA with high honors from the University of Chicago Booth School of Business.