In its simplest interpretation, Harry Markowitz’s modern portfolio theory demonstrates that greater risk is positively correlated with return and thus greater risk provides investors with a greater return.
As laid out by Markowitz, investors have been rewarded by the risks they’ve taken broadly across asset classes. However, there are caveats that go along with Markowitz’s theory – that all investors agree on the underlying risk and return of each asset and that there are neither trading costs nor taxes.
Taking this one step further, within asset classes, especially equities, investors have extrapolated Markowtiz’s financial theory in making the assumption that higher-risk equities should outperform lower-risk equities. Yet numerous research papers, including research by S&P Dow Jones Indices, show that this just isn’t true. In fact, higher-risk equities tend to produce lower investment returns versus lower-risk equities over full market cycles.
Identifying Risk Factors
Risk characteristics are never static; these characteristics are dynamic traits, evolving with time as the markets fluctuate, react and change. Many businesses’ financial reports show seasonality, sprinkled with times of faster growth and periods of contractions. Sectors, industries and the individual companies within all exhibit varying trends of successes and failures. With a low-volatility approach that identifies stocks that are less apt to fall and rise rapidly, an experienced investment manager will look to mitigate some of these risk factors within a portfolio.
In order to maximize one’s return at constrained risk levels, it is important to first identify which risk characteristics may have the greatest affect on your portfolio. Fully understanding a company’s future prospects, their place within the current market structure and their past stock behavior assists in better understanding which factors to weight higher or lower during the construction process.
Avoid individual company and sector concentration risks. Research by Vanguard shows that building a broadly diversified portfolio across industries lowers one’s risk. Individual companies tend to announce failures without warning, exposing their investors to significant losses. This risk is minimized by investing in a diversified number of holdings. Distinguishing potential detriments among individual stocks is key to gaining a bigger picture of the risks you are carrying.
The key here is knowing the potential negative factors in your portfolio. Such knowledge can help you better construct a more ideal portfolio, one with lower downside risks.