The Power of “&”

Enhanced portfolio diversification

Dr. Ajay Dravid, Chief Investment Officer, Equinox Institutional Asset Management, LP
Originally published in the July | August 2018 issue

Most investors, whether institutional or individual, tend to believe that stocks are a good—perhaps even the best—investment in the long run. However, the reason for expecting good performance from stocks is perhaps not always clearly articulated: Quite simply, it is because they are risky.

The return–and risk–of stocks with bonds

This positive relationship between risk and expected return is quite intuitive. If you decided to lend money to the US Government or to your brother-in-law, would you charge them the same rate of interest? The latter proposition is clearly more risky, and a rational investor would expect to be compensated appropriately for bearing that additional risk. If the expected return on US Treasury bonds is 2%, for example, you may decide to charge your brother-in-law a 6% rate of interest (remember that this is the expected return at the time you make the loan: there is a chance your entire loan may not be repaid, which would reduce your realized return. That’s what risk implies: the possibility of getting less than you expected).

This logic can be extended to other investments. Let’s limit ourselves to stocks and bonds. [1] US Government debt is generally viewed as being risk-free, if we ignore inflation risk. A US investor would rank investment-grade senior corporate debt as slightly more risky than Treasury bonds, followed by subordinated debt, preferred stock, and common stock. The reason stocks are the riskiest is that they are at the bottom of the pecking order in terms of their claim on the company’s profit or cash flow. But the reason they can also be the most rewarding is that they are entitled to all residual profits, after paying off the other more senior claims in the corporate capital structure.

Historically, the performance of equities has varied widely over time and from country to country. Nevertheless, it would not be inaccurate to say that, over long enough periods (although it is not clear exactly how this should be defined), stocks have generally earned “reasonably good” returns. Modern Portfolio Theory (MPT), however, tells us that returns must be assessed relative to risk. While most of the widely-used metrics of risk are not perfect, the standard deviation of returns (often called volatility) and their maximum peak-to-trough drawdown(s) are generally considered fairly adequate risk proxies for most traditional asset classes.

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