Understanding Basic Risk and Return
The basic concepts of risk and return that all new investors should understand
The long-term out-performance of higher risk assets (e.g. equities, private equity, real estate, high-yield credit), over lower risk assets (e.g. developed government bonds and investment-grade credit), is explained by rational market participants demanding higher returns for taking on additional risks. This is illustrated by the historical distribution of asset class returns and their respective volatilities (risk).
Chart 1: Historical asset class returns and volatility (1979 - 2016)
The risk-free rate
Perhaps the most watched and followed rate in financial markets, the risk-free rate or yield on risk-free government securities, sets the benchmark by which other assets are valued. For U.S. dollar denominated securities, the U.S. 10-year T-note yield is the most referred to risk-free rate, affecting bonds and equity prices alike. Risky securities must offer a return premium over risk-free securities, to attract investment dollars.
The risk-free rate, while also determined by prevailing investors’ perceptions and market demand and supply dynamics, can be broken down into two components – inflationary expectations and real returns.
Inflationary expectations – Risk-free securities (especially intermediate and longer dated maturities) at the minimum, are expected to cover the rate of inflation. Inflationary expectations over the respective time periods, can be determined by subtracting the real yields on TIPS (treasury inflation protected securities) from nominal treasury notes/bonds of similar maturities.
Real returns – Classified as excess returns over the expected inflation rates, real returns offer investors increasing purchasing power of their invested monies. For example, a real return of 1% per year suggests that the invested monies will be able to purchase on average 1% more of goods and services each year. The level of real yields investors demand, depend on their perceived level of uncertainty regarding future inflation, and trust in central banks’ ability to keep inflation levels low.
Chart 2: Current U.S. inflationary expectations and real yields
Source: U.S. Treasury department
Chart 3: Historical U.S. 10-year inflationary expectations and real yields (2003 - 2018)
Source: U.S. Treasury department
Fixed income - The credit spread
Bonds, loan instruments and other fixed income vehicles offer a credit spread premium above the risk-free rate, to compensate investors for the additional risk of default. Rating agencies such as Standard & Poor’s, Moody’s and Fitch, provide credit ratings to corporate bonds and other fixed income instruments. Higher-rated bonds are deemed to have lower risks of default, and hence offer investors a lower credit spread to risk-free rates, compared to lower-rated bonds.
Unlike risk-free yields, which typically fall when economic prospects are grim due to lower inflationary expectations, credit spreads rise. Corporations, faced with lower growth prospects and declining revenues during economic slowdowns, face higher borrowing costs and risks of default. Conversely, when economic activity gathers steam, typically risk-free yields rise and credit spreads fall, as a stronger economy is expected to cause higher inflation eventually and result in better business growth prospects. For this reason, corporate bonds are typically positively correlated to equities, while treasuries and risk-free securities are typically negatively correlated. The strength of these relationships becomes especially profound during periods of severe market distress, such as during the global financial crisis in 2008-9, where investors abandoned even the highest-rated corporate bonds for the safety of treasuries.
Chart 4: Current credit spreads on bonds of 10-year average maturities
Chart 5: Historical credit spreads of 10-year average maturity Aaa-, and Baa-rated corporate bonds (2003 - 2018)
Equities - The implied equity risk premium (ERP)
Equity markets can be tricky to price relative to the risk-free rate, due to the vagaries of estimating expected future growth (g) and expected future return on equity (ROE). The implied equity risk premium (ERP), which is a measure of the excess returns over risk-free rates that investors currently demand from equities, can be estimated using different methods, including – As a function of future shareholder returns by estimating future dividend and share repurchases; or as a function of the stock market index’s expected earnings growth and expected return on equity (ROE). Both methods described aim to estimate the expected future earnings available for shareholder distribution.
For simplicity sake, we will use the latter computation as an estimate of current implied equity risk premium.
Assuming a perpetual future earnings growth rate (g) of 5.00%, current 10-year treasury yield of 3.00%, and return of equity (ROE) of 16.00%:
From our example, we have determined that the implied equity risk premium investors demand from the S&P 500 index, is 5.89%.
When uncertainty in markets increase, equity risk premiums rise. Conversely, when uncertainty falls, equity risk premiums fall. Because investors logically demand higher return premiums when they perceive greater risks ahead. In 2018, we saw stock market declines despite robust earnings growth and rising business confidence, as concerns over U.S. – China trade war rhetoric, and rising inflation risks weighed on investors’ minds.
Because implied equity risk premiums (ERP) considers current risk-free rates, expected earnings growth (g) and return on equity (ROE), it is a better indicator of market under-, or over-valuation compared to measures such as Price-to-earnings, Price-to-book, or EV/EBITDA ratios.
Implied equity risk premiums can be compared across time periods, and geographic markets to determine relative under-, or over-valuation. Typically, investing during periods of higher implied equity risk premiums (periods of market distress), have led to higher returns.
Chart 6: Historical U.S. (S&P 500) Implied Equity Risk Premiums (2001 to 2017)
Source: Prof Aswath Damodaran at http://pages.stern.nyu.edu/~adamodar/
Chart 7: Implied equity risk premiums across major geographical markets, as of 28 Feb 2018 (Based on the dividend discount model, and excludes future expected stock repurchases)
Diversification - the free lunch?
Due to non-perfect and in some cases, negative correlations between asset classes and geographical markets, we can achieve superior risk-adjusted returns by holding carefully constructed diversified portfolios. Contrary to often deployed simple measures of risk that financial institutions often use, such as: “Conservative”, “moderate” and “aggressive”, by tracking co-variances and correlations between different investments, investors will find that by adding certain “aggressive” investments, they can achieve lower portfolio risk (as measured by volatility) yet increase their portfolio’s expected returns.
Looking back at historical asset class returns from 1979 to 2016, as displayed in table 1, we compare two hypothetical diversified portfolios to single asset classes that have similar returns or risk (volatility).
Chart 8: Historical asset class returns (1979 - 2016), including our 2 diversified portfolios
The results are showing – Each of our diversified portfolios far outperformed any single asset of similar risk (volatility), and by a wide margin. Diversified portfolio 1 outperformed long-dated treasuries of similar volatility by almost 3.00% per year, while diversified portfolio 2 outperformed TIPS of similar volatility by almost 2.00% per year.
Estimating future asset class co-variances, correlations, expected returns and volatilities, to construct optimal portfolios is no simple task to be certain. Recent evidence also suggests that geographical equity markets are becoming more correlated, bonds are experiencing bouts of positive correlations with stocks, and financial risk assets experience very high correlations during periods of market turmoil.
Despite this, an understanding of long-term and short-term co-variances and correlations between asset classes, as well as how they are trending, can go a long way in building resilient and superior risk-adjusted portfolios.