The relationship between risk and return is maybe one of the basic principles of investing. However, we have been taught since our childhood to have a risk aversion bias. This article is not about how good is to take risks. But how important is to understand when you are in the best position to take them. No Guts no Glory
Broadly speaking, numerous studies show that in investing there is a direct relationship between the risk you take and the return you have. This is an easy concept to understand. Investors demand a premium, in the form of a higher return, to compensate them for taking a higher risk. However, in investing nothing is guaranteed. There is the possibility of glory, with the necessary understanding that there can just as well be agony.
The role of small and large stocks in the portfolio
As the graph shows, the highest returns are obtained with the most volatile assets. It is noteworthy that it is true in the long term. Stocks are much more volatile than bills and bonds. During a crisis, if an investor holds stocks, probably their portfolio is going to experiment huge losses. In the same way, in a bull period, the portfolio is going to lag behind the market if it has a considerable exposition to fixed income.
It is easy to spot that even within the stocks, there is a vast difference between large and small stocks. Small companies are more vulnerable to the consequences of a crisis. One of the reasons for this can be their lack of access to credit in this period. C
Think about that, Google, Facebook, Amazon, Apple… all of them were in the past small caps, and the holders of these stocks at the beginning of their runs are probably millionaires today if the had the temple to hold the stocks).
Even within larger and smaller stocks, there are differences between Value companies and Growth companies, but this is a debate for another day.
Investors exposition to risk depends on several factors such as age, job, family, personality…
Common sense says that it is not the same an 80% volatility in the portfolio for a 25 years old investor than to others close to their retirement. Young investors can play more aggressively as a loss on their thirties is not the same as a loss on their seventies. 30 years old investor has all their life to continue making money for retirement. Consequently, the risk/return equation can be more inclined towards risk when the investors are young. In the same way, there are also other factors which conditionate this balance such as the fact of having children to take care, the personality or past experiences that the investor has, the type of job…
The first step to each investor should be to understand the amount of risk exposition that they feel comfortable with. And only after that, the investor can choose the best portfolio to fulfil their goal.
The Portfolio Allocation should be aligned with the investor’s investment goal
This concept is important to understand, an investor cannot pretend to obtain huge profits investing in large Utility companies, or companies with Beta = 1. In the same way, it is quite difficult to become a millionaire without exposing their portfolio to a higher than average volatility.
As it has been shown before, small stocks are much more volatile than larger stocks. Differently to what people are taught, the
Even if some investors do not feel comfortable with stock picking or actively managed funds. There is index funds and ETFs containing only small stocks with higher returns than the average of funds. These funds are also more volatile than other funds. However, it can be a good way to invest in someone who does not want to pick individual stocks.
Conclusion about risk returns
We are not saying that investors should take more or fewer risks, the takeaway here is to understand that portfolios should be aligned with the investment goals of investors. If one person wants to have minimum volatility and sleep well at night, its portfolio should minimise the expositions to stocks and avoid small caps companies. On the contrary, if someone wants to obtain high returns, its portfolio will be filled with small and volatile stocks.
Note: In the article No Guts