Read any decent book on passive investing and you’ll learn about clusters of equities with the potential to turbocharge your returns. These equities deliver return premiums, and by favouring them you can customise your portfolio much like a car modder might bolt a giant spoiler onto his Vauxhall Astra.

Modifying your portfolio like this unlocks the potential for greater performance in exchange for extra helpings of risk.

But how big are these premiums, and are they worth playing for?

Return premium size and volatility

Return premiums have historically been handsome. And they’ve delivered over prolonged periods of time, too, although we can’t know if their pep will stretch into the future.

The table below shows an example of US return premium pay-offs. It’s taken from a paper published by Robeco Asset Management and is available in full from the Journal of Index Investing:

The excess return column on the left shows the result delivered by each return premium portfolio over and above the return offered by ‘risk-free’ government bonds, between 1963 and 2009.

If you swoosh your eye to the right-hand column, CAPM Alpha, you can see what each return delivered on top of the broad US equity market, after adjusting for risk.

Particularly eye-catching is the extra 4.6% annualised excess return from the value and momentum portfolios – albeit at the expense of extra volatility.

Very tempting.

Risk it for a biscuit

That volatility column is not to be dismissed lightly. It shows that only the returns of low volatility stocks are subject to less violent swings than the equity market. (The clue is in the name, I guess).

Investors in return premium strategies therefore have to be able to tough it out when the market gives your cunning plan a right booting. Individual premiums have lagged the market for 10-20 years during the roughest patches.

But what the Sharpe ratio tells us is that time spent adrift in the choppy seas of risk has proved worth it for the higher overall returns.

The higher the Sharpe ratio, the better the risk-reward trade-off. And every return premium portfolio beats the market in this respect.

Indeed, the momentum and value portfolios deliver a risk-adjusted reward that’s almost double the market index.

Correlation

It gets better. There’s plenty of evidence that the pitch and yaw of multiple return premiums has diversification advantages when combined in a portfolio.

The Robeco paper illustrates this nicely by showing the relative lack of correlation between the return premiums:

• A correlation score of 1 means that two assets move up and down together.
• -1 means they move in opposite directions.
• 0 means that the relationship is random.

Any score from around 0.3 to -0.3 implies a lack of correlation, which accounts for most of the relationships above, bar value with low volatility and small cap stocks.

However, value has been known to decouple from low volatility when recession strikes and value stocks come under pressure.

The lack of correlation between the different premiums implies that some may wax while others wane, rather than all plunge together like climbers on a rope.

Diversification

Here’s another study from the Journal of Indexes (Europe) that shows the diversification benefits gained by melding return premiums into a joint portfolio, between 1990 and 2011:

• The S&P 500 stands in for the market portfolio.
• Fundamentally Weighted is a value premium strategy.
• Equal Weighted is a small cap strategy.
• Alternative Beta Composite is a portfolio that is divided one quarter each into the value, small cap, low vol and momentum strategies.

Note that the combined portfolio beats the market by 2% a year and with much better risk adjusted returns (see the Sharpe Ratio).

Even the overall risk is slightly lower – 14.2% as compared to 15.1% – indicating that the different equity strategies mesh together to create a stronger, more stable package.

We can see that the low volatility strategy has the best risk-adjusted returns and lowest risk overall, but it would be a courageous investor who hangs their hat on that bravura performance continuing. As always it’s best to spread your bets.

To illustrate the point, investment strategist and Larry Swedroe’s co-author, Jared Kizer, has analysed the likelihood of return premiums triumphing over longer time frames.

Kizer looked at US stock market data between 1927 and 2011 and came up with this table:

Over monthly periods, you can see that the chances of positive returns for size and value are only a smidgeon over 50-50.

Happily, performance is more satisfactory over longer horizons, though you still have to be prepared for size and value to lag the market 25% of the time over five-year periods.

More interesting still is the table below from Kizer showing that one of the premiums will bring home the bacon 96% of the time:

If diversification is a free lunch then let’s make it bacon sandwiches!

Caveat City

The strength of the return premiums change over time, by country and indeed according to how each premium is defined. So the numbers above may well differ from the results of other studies, and from the results in the UK.

Moreover, strategies that attempt to capture return premiums in reality tend to have bigger holes in their butterfly nets than is allowed for by the academic studies that originally pinpointed the opportunities.

There is though plenty of evidence to show that the premiums have persisted across international markets and the historical record.

I’ve seen enough to make me believe that it’s worth tilting my portfolio to collect at least some of the extra return juice. We’ll delve deeper into the possibilities in forthcoming posts.

Take it steady,

The Accumulator

Good reads from around the Web.

This week we’ll see the Chancellor deliver another uninspiring budget. Everyone knows the economic figures will be bad, and nobody knows what to do about it. (Certainly far more unites our political parties than divides them).

My early optimism in 2010 about a return to growth in the UK turned out to be wildly misplaced (although happily it hasn’t retarded the UK stock market).

Like most people I underestimated how long the global crisis would drag on for – we haven’t seen the likes of this for 60 years. And while I knew UK consumers were living according to precepts of Brewster’s Millions, I didn’t appreciate just how ruinously this dovetailed (IMHO) with excessive state spending to produce a double-whammy of living beyond our means. Now we’re catching up with reality.

I used to think the Coalition government was making the best of a bad hand, but I’ve now concluded they’re simply way out of their depth in facing this challenge.

We all have our own opinions about why most politicians are now basically PR men and self-confident ex-public schoolboys largely untested in the real world. Personally I think the electorate must take most of the blame.

For example, I was rooting for Obama not Romney in the recent US elections, but you only have to see how the latter was vilified for his infamous 47% comment to understand that free debate is toxic in modern politics.

Better than nothing

In any event, there’s no evidence we’ll see anything bold from this lot. Even the things they’ve got right they’ve inched towards half-heartedly, and they’ve embraced stealth taxes to boot.

Being bolder would have at least been good for our animal spirits. I’d have raised the £10,000 personal allowance at a stroke, for example, which would have raised real incomes for the poorest, sent a clear signal about rewarding work, and delivered a boost for the economy.

I’d have been cleverer on spending, too.

I don’t apologize for seeing the need to make many of the cuts the government has started to make. State spending and a growing entitlement culture needed curbing in my view, even without the gigantic IOU left by the financial crisis.

But I’d have offset at least some of these cuts with targeted infrastructure spending. Now is the time for the government to borrow a few billion at today’s bargain rates to build a new town or two in the South East, for instance. Damming the Severn Estuary to create a massive hydroelectric resource would have been another capital spending project I’d have put into place. There are others.

I understand infrastructural spending has a mixed record, but in my view it’d be great for morale. And even if we end up slightly down on the deal in fiscal terms, at least a few hundred thousand young people would have been employed and would have had a better chance of one day owning a home. And there would be slightly less need for fossil fuels in the future, too.

Fiddling while Romford burns

Big bold actions like radical tax reform – say an across-the-board flat rate tax of 30% and all exemptions out the window – are unthinkable with these leaders.

Instead we’ll get more tinkering.

On that note, be especially alert to talk of changing the Bank of England’s inflation remit. The Bank’s own chief economist Spencer Dale warned as much this week in The Telegraph:

The lesson from history has been the best a central bank can offer for “a prosperous and vibrant economy was to deliver enduring price stability”, Dale said.

“Recently, there have been some worrying signs that cracks may be appearing in that consensus. A sense that inflation is somehow yesterday’s war. That central banks should focus more on growth. That a period of higher inflation may even aid the recovery. This is dangerous talk.”

Citing the experience of the late 1960s when policymakers let “inflation to get out of control after nearly two decades of price stability”, he cautioned against being “complacent about the risks posed by further stimulus”.

He added: “It would be irresponsible to repeat the same mistakes again.”

Dale is right to warn on this.

Today we find ourselves with political leaders who have never aspired to be much else. That means in my view that solving our problems via higher inflation – even if it means overall we’re worse off than we might have been – is an  appealing option, because the electorate doesn’t understand the real value of money.

Of course we could argue that politicians don’t, either.

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One of the side effects of using the word risk in investment is the connotations of bravery, cowardice, and going for glory.

Loading your investing decisions with such emotional baggage is about as healthy as loading your potato skins with cheese, bacon, and sour cream.

It’s not as if risk even has a precise meaning in everyday use. Risk is very different if we’re talking about taking a shortcut down a dark alley to the supermarket, a paratrooper going out on patrol in Afghanistan, or Warren Buffett spending $20 billion to buy a company.

I’m notoriously risk-averse in real-life. I emailed friends in vindication when the horsemeat scandal broke, since they’d all suffered from my pickiness about food.1 I’m not exactly the first one through the doors of a dodgy pub in a foreign city, and I avoid winter sports for the same reason Dustin Hoffman avoids flying in Rainman.

Yet when investing, my risk tolerance is as high as anyone I know.

True, everyone takes risks when they invest. I’ve one friend who shuns shares except for periodic punts on tech companies, and others who keep all their money in cash.

My first friend risks losing his entire investment – though not everything as most of his money is elsewhere in a business.

The second group risks losing the lot to inflation.

I believe my diversified, equity-denominated portfolio is far less risky and potentially more rewarding. Yet my co-blogger The Accumulator quails if I tell him I’ve put a five-figure sum into a small cap property company.

For him it’s the risks of lagging the return from the market and losing out in trading costs that loom largest.

You call that a reward?

Even the flipside of risk – reward – means different things to different people.

My share-punting friend says he wouldn’t get out of bed for 6% real returns a year. He’d rather re-invest in his business. A reward for him, rightly or wrongly, is something that moves the dial now, not in 20 years time.

In contrast, I see him putting too many eggs in one basket.

My risk-averse mother isn’t fussed her portfolio of investment trusts increased its dividend payout last year. But she was excited when I told her the portfolio value had risen by so many thousands of pounds – even though the shares were bought for income, she many never sell them, and I’ve warned her they could as easily go down as up.

At the far end of the spectrum, the soldier in a warzone may be rewarded for putting his body armour on. He might only lose a leg, not his life.

Because you’re worth it

Risk, then, is a personal thing. You say to-may-to, I say tomato, you say banana, I see a banana skin.

This may seem obvious, but in my experience it’s not.

I was recently challenged in the comments on Monevator because I said pound-cost averaging a lump sum into the market was a sensible strategy for some people, if it reduced the chances of them losing a great deal of their new money in a sudden crash and they couldn’t emotionally take it.

The counter-argument was that over most periods, investing a lump sum immediately has delivered a higher return. Pound cost averaging was therefore “irrational”, and I should try to get people to see that.

But I don’t think it is always irrational.

Many people would happily take 5% returns over 20 years instead of 6%, if it meant a much smaller chance of losing 30% in any one year.

Certainly people should know the risks and rewards of their choices. However the decisions they make are not irrational just because they have an emotional component – and certainly not just because they reduce the potential return.

To say otherwise is to look at only one side of the equation – like speeding without considering the chances of a crash (or a divorce and a spell in jail!)

Even financial advisors have my sympathy when it comes to advising clients about risk.

What a terrible job!

Most people are more risk-averse than they think, and hate losing money. Whereas gains they shrug off as the natural order of things.

Yet few people go to a financial advisor to hear how to make a fairly secure 3% real return a year.

The crying game

Unfortunately, even if you agree that risk taking is a matter of personal choice, it’s difficult to judge your own tolerance ahead of a market crash, a recession, losing your job, or whatever else life throws at you.

(We’ll ignore the ‘upside’ problem of your returns being much higher than you expected. That’s only a drawback in the world of academics!)

You might vow to regard risk as just as important as reward, and choose an appropriate portfolio. But that’s a rational decision, not an emotion, and we’re emotional creatures.

The danger is that when the shares hit the fan, your emotions will take over, with damaging results.

Education can help. You might know you’re very afraid of losing money, say, but you’re convinced by the historical return from shares. So you could read all about previous stock market cycles to prepare mentally, and maybe begin trickling a small amount of money into shares over the next few years to get started.

The snag is we only live once. Take too long getting comfortable with risk and you might not have enough time to get a reward.

Worse, even a decade of experimenting might not tell you much. Plenty of investors in the 1990s felt very confident about shares. Only the thought of missing out on the biggest gainers bothered them! Then two bear markets in a decade slammed them for six.

Equally, some people seem wired for silly risk taking. Las Vegas exists because such people will always shrug off losses to try to make back their money.

My share-punting friend will probably never change. The best I can do is encourage him to lock some regular savings away in a pension fund, and hope he doesn’t learn about self-managed SIPPS!

How to explore your own risk tolerance

Here are some ways to better understand your own attitude towards risk.

Discover what others do

Read up on rules of thumb about risk, returns, and asset allocation. They’re not perfect but they are time-tested. Generations of investors have seen their fortunes ebb and flow, and these rules are the collective folk wisdom that’s been left when the tide’s gone out.

Stress test your portfolio

Instead of exclaiming, “What are the chances of that!” when someone says your portfolio is too risky, use a Monte Carlo simulator to find out. Is it worth a 10% chance of having no money at 75 for a 2% chance of having a maximum gain of £3 million, instead of £2 million? I’d suggest not.

Visualise the consequences

Look at photos of your parents when they were young, and again when they’re old. We have trouble imagining ourselves in our old age – but in most cases that’s who you’re taking risks for.

Try our risk tool

Experiment with the new risk tool here on Monevator, developed by the boffins at Which? It asks how much you’re prepared to lose in a year, and suggests different portfolios as a result. (I wouldn’t fuss over the exact asset allocations it suggests – thinking about the potential payoffs is the idea here).

Now none of these methods can really tell you how it feels to lose half your pension the year before you retired because you stayed 100% in equities too long.

But working through them puts risk and reward into the spotlight where it belongs.

Tip: Consider all the risks when making investing decisions. The first reason to invest is inflation, which erodes the real value of your money even as its nominal value stays secure. Over the long-term, inflation could be a bigger risk than temporarily losing 20-30% of your money in a crash.

Search for the hero inside yourself

Outside of the City and Wall Street, investing is not about beating the rest. It is not a macho sport.

I’d guess my own risk tolerance is higher than perhaps 90% of Monevator readers, although I’m not sure all of the newer arrivals to the market know it. I’ve seen my net worth plunge faster than the Liberal Democrat vote at a local election and I know I can endure it. In contrast the last few years have been a nirvana for shares, and complacency is building.

But despite my own attitude to risk, you won’t find me berating you for keeping 50% of your funds in cash, let alone for paying down your mortgage instead of gearing up to invest in shares.

Risk comes down to your own circumstances, goals, and your own gut feeling. Don’t take the risk of anybody convincing you otherwise.

1. I don’t think eating horse is bad for you – I think not knowing what you’re eating is. [↩]