Investors should only take risks that the market rewards--and that they can live with.
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 Treasuries 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 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 FDA approval, 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 unfavorable 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. Please reference this article for a more in-depth discussion of the low-volatility strategy.
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.
Low-volatility funds, such as PowerShares S&P 500 Low Volatility SPLV and iShares MSCI USA Minimum Volatility USMV, 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).