Risk equals reward, right?
This has been anconcept for more than a century. The notion implies that every delivers that account for their volatility and risk.
(which have ) generate modestly better returns than , have delivered better returns than over the long haul, and small cap , the riskiest of all, are expected to generate the best returns of all, at least for investors who can stomach the wild swings.
But is the adage really true? Are you really compensated for risk with better returns?
The answer may surprise you.
To see if you are taking on too much risk in search of rewards, let's turn to Stanford University professor William Sharpe, who devised a handy measure of risk-adjusted returns back in the 1960s. His "Sharpe ratio" is used by many academic as they delve into this contentious . The Sharpe ratio tells investors how much return they should expect for the risks they are taking.
If you have a keen head for math and want to see the formal mathematical equation of the Sharpe ratio, then here it is:
(Rp – Rf ) / Sp
OK, we're getting stuck in jargon here, so let's keep it simple, and take a look at how various kinds of stocks have performed, relative to the risk that they represent. Conveniently, economists at the American Association of Individual Investors (AAII) took a look at small-cap, mid-cap and large-cap stocks in an unusually volatile period, from January 2008 through July 2012. And they found largely what you would expect: Smaller stocks are riskier and more volatile.
But the story doesn't end there. Sure, they're riskier -- but what about the reward?
Well, it turns out that even after adjusting for risk (using the formula above) the better returns of smallerwere still worth the trouble.
"Although the S&P SmallCap 600 is more volatile and thus riskier, holders of thewere much better compensated for the risk compared to holders of the S&P 500 during that period," was their key conclusion.
This conclusion flies in the face of what many investors believe. "Small stocks are just too risky and not worth the trouble," you'll hear many people say. But studies have shown that the riskier the asset, the higher the returns, at least over the long haul.
To be sure, a portfolio of only small-cap stocks makes little sense. Small caps tend to move as a herd and can generate several years' worth of underperformance if the broader large caps and bonds. A nice blend of all of these assets is the way to go.is in the mood to favor
Frankly, trying to calculate the Sharpe ratio for your stocks is tricky, as a small sample size of just a few dozen stocks may skew the denominator (standard deviation), rendering the results moot. That's why investors more often use Sharpe ratios when assessing the performance of , and . These funds hold many different stocks after , thus creating a more meaningful set of figures to use.
TheAnswer: Your goal is to neither embrace nor shun risk. It's crucial that you hold some conservative in your portfolio so you can sleep well at night. But a portfolio with too much of a conservative tilt (i.e. only bonds and stocks) may prevent you from building a large enough portfolio that you can eventually rely upon in retirement.