Many academics agree: the method of beating the market is to assume greater risk. Risk and risk alone determines the degree to which returns will be above or below average, and thus decides the valuation of any stock relative to the market.
I. Defining Risk:
1. Financial risk has generally been defined as the variance or standard deviation of returns.
2. It is quite true that only the possibility of downward disappointments constitutes risk. Nevertheless, as a practical matter, as long as the distribution of returns is symmetric – that is, as long as the chances of extraordinary gain are roughly the same as the probabilities for disappointing returns and losses – a dispersion or variance measure will suffice as a risk measure.
3. Although the pattern of historical returns from individual securities has not usually been symmetric, the returns from well-diversified portfolios of stocks do seem to be distributed approximately symmetrically.
II. Documenting Risk: A long-run Study – stylized facts
1. On average, investors have received higher rates of return for bearing greater risk.
2. Stocks have tended to provide positive “real” rates of return, that is, returns after washing out the effects of inflation.
III. Reducing Risk: Modern Portfolio Theory (MPT)
1. Portfolio theory begins with the premise that all investors are risk-averse.
2. Harry Markowitz discovered that portfolios of risky stocks might be put together in such a way that the portfolio as a whole could be less risky than the individual stocks in it.
3. As long as there is some lack of parallelism in the fortunes of the individual companies in the economy, diversification will always reduce risk.
IV. Diversification in Practice
1. A portfolio of 50 equal-sized and well-diversified US stocks can reduce total risk by over 60%. As further increases in the number of holdings do not produce much additional risk reduction.
2. About 50 is also the golden number for global-minded investors. The international diversified portfolio tends to be less risky than the one of the corresponding size drawn purely from US stocks.
3. Investors may do even better by including stocks from emerging markets in their overall mix. Correlations between broad indexes of emerging market stocks and the US stock market are generally lower than those of the US stock market with developed foreign markets.
4. There are also compelling reasons to diversify a portfolio with other asset classes. Real estate investment trusts (REITs), enable investors to buy portfolios of commercial real estate properties. Real estate returns don’t move in tandem with other assets. For example, during periods of accelerating inflation, properties tend to do much better than other common stocks. Thus, adding real estate to a portfolio tends to reduce its overall volatility. Treasury inflation-protection securities do not mirror those of other assets and tend to provide relatively stable returns when held to maturity.
A Random Walk Down Wall Street - The Get Rich Slowly but Surely Book Burton G. Malkiel