Sources of Return

Investing is a matter of understanding systematic risk factors and deciding how much exposure to those risk factors a portfolio should have. The expected return of a diversified equity portfolio in excess of a risk-free rate (defined as the return on US Treasury Bills) is a function of that portfolio's sensitivity or exposure to three risk factors:

Market Factor

Capital Asset Pricing Model - William Sharpe: Nobel Prize in Economics, 1990

• Equity risk is a combination of systematic and unsystematic risk.
• Systematic risk includes macroeconomic conditions affecting all companies in the stock market. Systematic risk cannot be diversified away.
• Unsystematic risk includes company and industry developments specific to individual securities. The effect of these can be reduced through sufficient diversification.
• Investors should not expect markets to reward them for risks that can be diversified away. They should expect compensation only for bearing systematic risks.

• The size and price (book-to-market) effects appear in both US and international markets—strong evidence that the risk factors are systematic across the globe.
• Small cap stocks are considered riskier than large cap stocks, and value stocks (as defined by a higher book-to-market ratio) are deemed riskier than growth stocks. Higher returns reflect compensation for bearing higher risk.
• From year to year, small cap and value stocks do not always produce higher returns. Over longer time periods, the size and value premiums are more prevalent. Investors that maintained disciplined size and value exposure were ultimately rewarded.
• A multi-factor approach incorporates both size and value measures—and exposure to non-US markets—in an effort to increase expected returns and reduce portfolio volatility.

Next: Structure