## What is the Relationship Between Risk and Return?

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Nov 06, 2014
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Behavioral Finance, Question of the Day, Investing, Chart of the Week

Hat tip to Dr. Barbara O’Neill, Rutgers Prof. for tweeting about this resource which provides return and standard deviation data on different asset classes over different time periods: Stocks, Bonds, Bills and Inflation.

Here’s the chart that provides a time series (logarithmic scale) of how the value of each of these assets has changed over time (adds details on large company value and S&P500 returns):

Have the students interpret each resource (the table as well as the time-series) and lead them on with additional questions:

• Using the first resource (the table), rate the four assets from highest return to lowest return over:
• 1 year (yes it was a great year in the stock market, not so much for bonds and bills):  Small company stocks (45.1%), Common Stocks, S&P500 (32.4%), LT Corporate Bonds (-7.1%), Treasury Bills (0%)
• 5 year:  Students to complete
• 10 year: Students to complete
• 20 year: Students to complete
• 88 year: Students to complete

Once students complete this exercise, they should notice a persistent pattern in the order of the asset classes from highest to lowest return.  Now have them rate the assets from highest to lowest based on their standard deviation (from first resource).

First, what is standard deviation?  A risk measure used by investors to provide a sense of how varied a given asset’s return will be.  So, a high standard deviation indicates that an asset’s returns will fluctuate more than an asset with a lower standard deviation.  Even with a logarithmic series on the time series, you can see how the high performing assets have more fluctuations.

So, how do the assets vary based on their long-term standard deviation?

• Small company stocks:  32.3%
• S&P500:  20.2%
• Long-term corporate bonds:  8.4%
• Treasury bills:  3.1%

There you have it, the assets with the highest return (small company stocks) also has the highest risk (as measured by standard deviation).  Someone will ask, if this is the case why not invest 100% in small company stocks since they have the highest return.  A few thoughts:

• While this small company outperformance has persisted for some time, the past is no guarantee of future performance so better to diversify and hold multiple a mix of different assets.
• If you do make this decision, given how much the small company stock prices will jump around both up and down (remember they have a high standard deviation), you better have the right risk profile so you don’t sell when the stock prices decline.  This is where behavioral finance plays a role and often leads investors to be their own worst enemies.

Extension questions

• Why do small companies have greater returns?  If you answered, “They are riskier”…you are right.  Why are they riskier?  In short, it is harder to forecast their performance and their futures are less certain.  Much easier to predict the performance of Coke next year as compared to a small-cap biotech company seeking approval for a new drug.

From AAII research:  “Small-cap stocks tend to have three primary characteristics that diminish the visibility of future cash flows. First, small-cap stocks will often have shorter track records upon which to build cash flow assumptions. Second, small-capitalization companies may be less widely followed by Wall Street analysts. Lastly, investors may perceive small-capitalization stocks as more economically sensitive assets. All of the above factors may have implications as to when small-cap stocks should theoretically outperform less risky equity assets.

• We know that Treasury Bills have the lowest returns over many of these time periods.  What is a Treasury Bill and are they risky?

From Investopedia:  “A short-term debt obligation backed by the U.S. government with a maturity of less than one year.”

Key phrase is “backed by the U.S. government” which makes this as close to a risk less asset as any asset on the planet (some may debate me on this but a subject for another day).  Note that if you are totally risk averse and put all of your investments into T-bills, the risk YOU DO HAVE is that you won’t keep up with inflation.  Note that over the past year T-bills returns have been a big fat 0% while inflation (which increased the cost of a basket of goods you purchase) rose by 1.5%.