From an investing standpoint, there are a few concepts that are critical to remember:
First is diversification and the way assets are priced on the capital market. You don’t get rewarded for taking risks that are diversifiable. This means that from a risk and return standpoint, you are much better off holding a diversified portfolio.
The second thing to remember is that more often than not, there is no free lunch. The market is pretty efficient at eliminating arbitrage opportunities. If something looks too good, it probably is too good to be true.
Third, there is a positive relationship between risk and return. You can always get higher returns if you are willing to take more risks. But risk is a double-edged sword, so you can also lose more.
The fourth thing is that how much risk you are willing to take is really a function of what your time horizon is. Typically, if your time horizon for liquidating portfolios is short, then you want to take less risky portfolio positions than if your time horizon is longer. If you want to be rewarded for taking risks, then you need to have a fairly long time horizon. In the financial market, when it comes to risks, long really means longer than ten years. If you need to liquidate in less than ten years, then that is something that could affect your portfolio position. You want to stay away from less liquid and more risky assets and move more into less risky and more liquid assets.
We typically distinguish among assets on two dimensions. They are related, but they are distinct concepts. One is risk and the other is liquidity. If you look at the risk dimension in traded assets, the riskiest assets would be options. The next riskiest category of assets would be small-firm stocks, then large-firm stocks, and then bonds. Bonds have different ratings, ranging from junk bonds, which are the riskiest kind of bonds, to government Treasuries, which are the safest kind of bonds.
Along the liquidity spectrum, there is a whole variety of assets, as well. Real estate is very illiquid, especially if it is undeveloped real estate. Stock is very liquid because there is an active secondary market if the company is publicly traded. If it’s a privately held firm, obviously that is a less liquid stock. Typically, the more liquid a stock, the lower the risk is that when you need to sell it, you will be forced to sell it at some fire-sale price.
There is a dimension of risk associated with liquidity, as well. Because of the ability to buy and sell, as opposed to an inherent risk-return tradeoff, liquid assets, just like more risky assets, typically deliver a higher rate of return. If you have a very long time horizon, dispose of assets in a timely manner. You may want to hold some liquid assets in your portfolio to take advantage of the higher rate of return. Historically, there is a hierarchy if you want to hold a portfolio for a long time. Among stocks and bonds, the hierarchy is that small-firm stocks yield the highest expected rates of return. Large-firm stocks come second, and then bonds come third. The lowest rate of return over the long haul is with Treasury instruments. They are the most liquid and the safest. As you are putting your portfolio together, this is the hierarchy of instruments from which to choose. There must be the right balance between liquidity and return and the right balance between risk and return.
Another useful lesson to remember is that historically, the difference between the rate of return on a diversified portfolio of equities and long-term government bonds has been about 7 percent. If you hold a diversified portfolio of stock for a long period of time, on average per year you will earn about 7 percent more than you would get if you invested in long-term Treasury bonds. Let’s say that the rate of return on Treasuries is 5 percent, and let’s say you were to invest in the market. You should expect about 12 percent, given the risk. Looking at the 1990s, when investors were getting 20 percent to 25 percent per year, we should have expected that it wasn’t going to last forever. In a sense, we are now paying back for getting such high returns in the 1990s. Eventually the market returns to its long-run equilibrium. The good news in that is that once we pay back, then we have better times to look forward to.
The formula for the positive relationship between risk and return is called the Capital Asset Pricing Model. The Capital Asset Pricing Model basically tells you what the expected return on a stock should be, given its beta, or its systematic risk. If you are going to be a portfolio investor or if you are going to be in the market, that is something you should know. The formula says that the expected return on any stock is the long-term government bond rate plus the stock’s risk, which is the beta, times this market-risk premium of 7 percent that I mentioned. If my risk-free long-term government bond rate is 5 percent, and I have a stock that is one-and-a-half times as risky as the market, then the expected return on that stock would be one-and-a-half times 7, which is 10.5, plus the 5 percent risk-free rate, or 15.5 percent. This is the rate of return I would need on the stock to invest in it.
There is a relationship between the return you can get on fixed- income instruments and the maturity of the fixed-income instruments. That relationship is called a yield curve. The yield curve basically says that for any maturity there is a rate of return that you can get by investing in that instrument at that maturity. If you invest in longer-maturity instruments, you get a higher rate of return than if you invest in shorter-maturity instruments. If you were to put your money in three-year Treasury bonds, you would get more money than if you put your money in three- month Treasury bills. You are being compensated for investing in an instrument that is more volatile and riskier. The longer the maturity, the greater the price risk of maturity. If you are putting a portfolio together as an investor, you have to understand that you can typically get a higher return by investing in longer-maturity instruments, but you are taking more risk if you don’t plan to hold the instrument all the way through to maturity.
There are also some important lessons on options. If you don’t thoroughly understand options, the best thing to do is to stay away from that market if you are a retail investor. Options are extremely risky. Unlike with stocks, you don’t have the opportunity to be patient once the option expires. The last lesson, related to options, is that options written on more risky stocks typically have more value. As the risk of the stock on which the option was written increases, the value of the option goes up. If you are looking for options with a lot of upside potential, you want to buy them in companies whose stock is very risky, which is the exact opposite of the way we normally think about value and risk. Risk is typically bad for stocks, but it is typically good for options.