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.

Equity strategies to reduce risk

It is still possible for a diversified portfolio to offer an unfavourable risk/reward profile. Contrary to the predictions of the capital asset pricing model, there is little empirical relationship between an asset's sensitivity to market movements (beta) and its returns. In fact, assets with the highest betas have historically offered the lowest returns relative to their volatility. This might create an opportunity for investors to reduce risk without sacrificing much return by overweighting low-volatility stocks.

Low-volatility stocks tend to lag during bull markets. Investors who are unwilling or unable to use leverage to boost their performance may be drawn to riskier stocks, causing them to become overvalued relative to their risk. Investors may also overpay for volatile stocks because they could offer a small chance of a large payoff -- much like a lottery ticket.

Volatility itself can create a drag on performance. For example, the table below illustrates the performance of two stocks. Stock B is twice as volatile as stock A. Even though they have the same simple (arithmetic) average annual return, stock B has a lower compound return. The compounded rate of return is always equal to or less than the simple average holding-period return. As volatility increases, so does the gap between the simple and compounded rate of return. This is called volatility drag.

Volatility drag
Stock A Stock B
Return Growth of $10 Return Growth of $10
Year 1 5% $10.50 10% $11.00
Year 2 -5% $9.98 -10% $9.90
Year 3 5% $10.47 10% $10.89
Year 4 -5% $9.95 -10% $9.80
Simple average 0% - 0% -
Compound return -0.13% - -0.50% -
Source: Morningstar analyst calculations

Low-volatility ETFs, such as BMO Low Volatility Canadian Equity ZLB and iShares MSCI USA Minimum Volatility XMU, allow investors to reduce volatility drag. There is a cost to holding these funds. They will likely lag in bull markets but shine during market downturns. Over a full market cycle, that may allow investors to earn returns that are comparable to the market's, with less risk. However, this strategy could become less effective as more investors attempt to take advantage of it.

Investors may obtain a similar improvement in performance during market downturns by targeting quality stocks -- those with strong profitability, sustainable competitive advantages and stable earnings. While there is some overlap between quality and low-volatility stocks, not all quality stocks exhibit low volatility (  Google  GOOG, for example), nor are all low-volatility stocks highly profitable (such as most utilities).

  3M  MMM is a good example of a quality stock. The firm makes a wide array of consumer and industrial products, including adhesives and tape (Scotch tape), sealants and filtration devices. It enjoys a strong patent portfolio and cost advantage relative to many of its peers, and it invests aggressively in product development to maintain its edge. This gives the firm a wide economic moat. 3M's products tend to make up a small part of its customers' overall expenses. Keith Schoonmaker, Morningstar's director of equity research responsible for covering the industrials sector, argues that this means customers are more likely to look elsewhere to cut costs before switching from 3M products. This gives the firm some flexibility to increase prices. During recessions, quality companies like 3M are likely to experience smaller declines in earnings than their less advantaged competitors, which may have to rely more heavily on price cuts and may struggle with higher costs. As a result, quality companies tend to carry less business risk and may help investors better preserve their wealth during market downturns.

Portfolio strategies

While investors may be able to reduce risk in their equity portfolios by overweighting quality and low-volatility stocks, it may still be necessary to limit exposure to stocks. The best course of action is to only take risks you are comfortable with. Generally, the probability of loss in volatile asset classes is greatest over short horizons. Therefore, it is good practice to keep any money you need in the near term (less than three years) in less risky assets, such as cash and short-term investment-grade bonds. But even investors with long time horizons could do well to reduce their exposure to stocks if they do not have the stomach for large market fluctuations. Many investors panic and sell when the pain of loss becomes too great, only to jump back in the market when times are good and valuations are inflated. This may explain why investor returns tend to lag the returns of the funds they invest in.

Limiting exposure to stocks can create high opportunity costs. Protective puts may be a viable though expensive alternative. Put options act as insurance against a decline in the value of an asset and give investors the right to sell an asset at a predetermined price, which allows investors who hold that asset to cap their potential losses while participating in any upside. But like insurance, investors must pay a premium for that protection, which can erode returns. Investors can reduce the cost of this protection by purchasing put options with lower strike prices, thereby accepting greater risk and only insuring against big losses. Put options allow investors to stay in the market even after the market price drops below the strike price (investors can sell the option to recognize the offsetting gain).

Stop-loss orders serve a similar function as put options and do not carry an explicit cost. However, unlike put options, these orders kick investors out of the market when they are triggered, which may result in capital gains taxes and missed opportunities. A spike in market volatility can trigger a stop-loss order even if the decline in value was only temporary.

There is no silver bullet to manage the trade-off between risk and returns. However, it is imperative to only take risks that the market compensates and that you are comfortable with. Investors' risk preferences should govern their return objectives, not the other way around.

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.