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Issue X

December 1996

Sharp Investing

What to Expect When
You're Expecting

In investing, the future is truly unpredictable. The best that any smart investor can do is to use methods that have worked best in the past and apply them to the future in the hope that history repeats itself. History almost always repeats itself in the long run, and seldom does in the short run. Historical precedence can be very useful if correctly viewed. Unfortunately, human nature warps investor perceptions, usually by overweighting the importance of the very recent past, and discounting the more important long term past. This creates unrealistic expectations of the future. A recent survey shows that three out of four investors believe that the stock market will not have a correction of 20% or more for the next ten years! This in spite of the fact that markets have had such corrections on average once every five years for the last 70 years. Six years of a market unchecked by even a 10% correction (the longest period ever) has warped the expectations of the future of 75% of all investors. This same survey taken in November of 1987, or the summer of 1990, would surely have yielded vastly different results.

Understanding the expected risk and return of various investments is incredibly important to achieving success in the financial markets. For example, the U.S. stock market has an expected return of 12% and an expected risk of 21% during any given year, based on the last 70 years of historical precedent. Everyone understands what a 12% return means, but few understand what a 21% risk level means. A 21% risk on a 12% return means that one year out of three the market can expect to make a move either more than 33% (12% + 21%) or less than -9% (12% - 21%). One year out of six, the market can be expected to move more than 54% or less than -30%.

Of course, the odds of a large correction are currently much higher than usual based on the unprecedented run-up in market prices over the last few years. This is fact. Expecting the market to not experience a 20% setback for the next ten years is fiction. Investors must set expectations based on long term historical results.

The next area of unrealistic expectations comes from the over-simplification of the risk-return relationship of all investments by the financial services industry. In today's world of the packaged financial product (mutual funds or variable universal annuities) most financial salespeople justify their additional fees via the perceived value added of asset allocation. Bonds are seen as less risky than stocks and therefore pay less return. Derivatives are seen as more risky than stocks and therefore are assumed to pay a higher return. For the asset allocators, it becomes a simple matter of measuring their client's risk and plugging the numbers into their asset allocation software, which tells them to put X% of the client's money into bonds, Y% into stocks, and Z% into some other asset. It is simply assumed that the risk-return tradeoff is equal among investments. However, this tradeoff is far from equal. Stocks, as a group, provide much higher return for their given level of risk than most other investments, as shown by the table below. To add insult to injury, most asset allocators will sell investors stock funds and bond

funds, which each have a lower expected return and higher expected risk than direct investment in stocks and bonds.

Risk and Return 1952-1995*

Investors using an asset allocator and fund investments usually end up taking a lower return than necessary for any given level of risk. The higher the percentage of non-equity investments in your portfolio, the more inefficient your expected risk-return tradeoff. The higher the percentage of indirect (funds and annuities) investments in your portfolio, the more inefficient your expected risk-return tradeoff.

Sharp Investing is a quarterly publication focused on investment education. For a subscription contact
Sharp Investments, at:

13160 SW Butner Road
Beaverton, OR 97005
Phone 503-520-5000

Fax 520-0530 email:
Daniel R. Sharp
Registered Investment Advisor

Expected Risk and Return in the Stock Market

Within the stock market itself, expected risk and return is vastly misunderstood by the majority of investors and many financial professionals. It is widely and incorrectly assumed that the riskier a stock, the higher the expected return. Therefore, your typical financial salesperson will sell high risk stocks such as aggressive growth funds and emerging market funds to high risk investors, and low risk stocks such as balanced funds and income funds to low risk investors. This assumption is best reflected by the use of Beta to pick stocks.

Beta, a measure of a stock's movement compared to the market in general, is a widely popular measure used by amateurs and pros alike. A Beta

Let's assume a retired person is comfortable with a risk level of 12%. A typical asset allocator might give them a boilerplate asset allocation strategy that called for 90% bond funds and 10% equity funds. This results in an expected return/risk ratio of (5.24-3.8%) /11.4% = .126. However, maximizing return for the stated level of 12% risk would optimally result in a mix of 33% stock and 67% bonds for a ratio of (7.55-3.8%)/12% = .312.

33% stock rather than 10% results in the same level of risk but with 44% more return.

Investors that understand that the stock market provides higher returns for any given level of risk can raise the expected return of their portfolio without raising the expected risk.

of 2 implies a stock twice as risky as the market, while a Beta of .5 implies a stock half as risky as the market. It's popularity stems from it's longevity (theorized in the 60's by William Sharpe as part of the Capital Asset Pricing Model) and it's simplicity. Beta has been grandfathered into many investment research strategies and publications. There's just one little problem. Shhhhh! Come closer. It's a secret: Beta doesn't work very well.

Researchers have had the capability for the last 10 or 15 years to run extensive empirical tests on academic investing theories and professional investing strategies using about 50 years of real data. Many academic studies have been done on Beta. The result - a very weak link. Higher risk stocks in the stock market don't necessarily mean high return. The link between expected risk and expected return in the stock market is not as simple as Beta.

The good news is that a much stronger link between risk and return has been discovered that is only a little more complex than Beta. What has been found is that stocks possessing certain characteristics have a much higher expected return/risk tradeoff than stocks that lack these characteristics. There are now more than 60 academic studies that all say the same basic thing:

Value stocks have much higher expected return and lower expected risk than growth stocks over long periods of time.
This is a commonly accepted fact among research circles, but is not among many investors. The reason: the financial services industry makes money by catering to human nature, not by telling investors about the stocks with the highest expected return/risk tradeoff. Financial services are no different than a lot of industries. Do you think the diet industry would have become the multi-billion dollar market it is if diet companies told people the way to lose weight is to eat less and exercise more? Do you think the investing industry would be the multi-trillion dollar market if it simply told investors that value stocks had the highest expected risk/return tradeoff? Value stocks can be defined in a number of different ways, but the general idea is that they are selling for less than their fundamental economic value.

Expected Risk and Return of Value versus Growth

The financial services industry has determined that telling an investor what works best is less lucrative than telling them what they want to hear. Investors want to hear about exciting high growth companies and willingly snap up the best companies in America regardless of the price they are being offered at. No one wants to hear that buying a mediocre company at a bargain price is a better investment (higher expected return, lower expected risk) than buying an excellent company at a very high price.

Need proof? A study was done in which the 50 companies with the highest earnings growth rates were purchased and held in a portfolio each year for 45 years. Additionally, the 50 companies with the lowest earnings growth rates were purchased and held in a portfolio each year for 45 years. Guess what? The 50 companies with the lowest earnings each year had higher investment returns than the 50 companies with the highest earnings each year.

This is the growth myth perpetuated by the financial services industry. They tout the high flyers because they make money selling them to you, not because you make money from investing in them.

High earnings do not translate to high stock performance if investors expect those high

earnings. A great company is not usually a great investment unless it is selling at a bargain price. Buying at less than fundamental value is a much more effective strategy than buying great companies at any price.

Growth versus Value 1952- 1995

Value stocks provide less expected risk and much more expected return. Note that both growth and value strategies are riskier than the market in general - but value compensates investors at 2 1/2 times the rate of growth and 1.8 times the rate of the market in general.

If $10,000 were invested in 1952 in either a growth or value strategy, or the market in general, in 1995 the results would be the following:

Growth stocks produced $386,000 in 43 years
The market in general produced $1.3 million
Value stocks produced $14.14 million

Maximizing Expected Risk and Return

At Sharp Investments we have further refined this advantage of value over growth by structuring client portfolios from a blend of the two best types of value based on 50 years of data. I call these two types of value Aggressive Value and Low Risk Value. Aggressive Value stocks are smaller, unknown, more volatile companies that have an expected return of 21.5% and expected risk of 26%. Low Risk Value stocks are big, familiar, stable, dividend paying stocks with an expected return of 16% and an expected risk of 17%. A 50/50 blend of Aggressive Value and Low Risk Value has an expected return of 20% with the same

expected risk as the market. That's 60% more return than the stock market with the same level of risk. Clients with low risk tolerances will have higher amounts of Low Risk Value and clients with higher risk tolerances will have higher amounts of Aggressive Value. In either case, investors are obtaining the highest expected return/risk ratio available no matter what their personal risk tolerances.

Recall the earlier example of the retired person with a risk tolerance of 12%. Using bonds and Low Risk Value would result in an optimal mix of 47% Low Risk Value stocks and 53% bonds, yielding 10.36% return with the same 12% risk.

Returns are almost doubled over the standard asset allocation strategies (10.36% vs 5.24%) with the exact same level of risk. A 98% increase in expected return without an increase in expected risk!

Understanding and accepting my little lecture on expected risk and return is no guarantee of success. Most investors have problems sticking to the rules. Most invest backwards. They find a company they like first, and then rationalize it's attractiveness as an investment second. There is nothing wrong with some subjective choice based on your perceptions of the company and it's prospects, management capabilities, etc., but the choices should come from stocks that fit the strategies that produce the highest expected risk/return tradeoff. There is also nothing wrong with using Beta to adjust your risk level as long as it is applied within the high expected return/risk group. Making exceptions and going outside the high expected return/risk group because the stock you like is "different" and worth bending the rules for, will negate the advantage gained by limiting your choices to stocks that fit the high expected risk/return profile.

Sharp Investments
13160 SW Butner Road
Beaverton, OR 97005

I do not follow, study, or otherwise concern myself with stocks that do not fit either my Aggressive Value profile or Low Risk Value profile. There are over 8000 stocks and 6000 mutual funds in the U.S. market alone, and I would lose my focus if I tried to follow the latest system, gimmick, or hunch. The investment world is full of distractions and the key to success is to focus on the right things. The distractions and wrong things make the financial industry rich - not you.

Individual stock picking is almost completely random. Wouldn't you rather make your random picks from the group of stocks with the highest expected return? Trying to find a high return stock from the low risk/return group is like trying to find a needle in a haystack. This concept is so simple to understand, but so difficult for most to implement.

This is why many investors chose to turn over their investing to a professional that will stick to a disciplined strategy for the long haul. Unfortunately, most professionals make their living by giving investors what they want (low expected risk/return investments - but exciting!) rather than what they need (high expected risk/return investments - but boring). If you are choosing an investment professional or have chosen to use mutual funds, be aware that the vast majority of both will be catering to what you want, not to what you need.

If you are one of the very few investors that can set the ground rules first, and choose the investments second, as my father has done for 36 years - congratulations! However, if you are like the vast majority of investors that confuse a good story or a good company with a good investment, make sure you find an investment professional or fund that will give you what you need, not what you want.
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