Leon Mehl

The unpredictable nature of economic change is a complicating factor in the field of investing, and ultimately affects both the risk and return of investments. Furthermore, investors possess imperfect information which makes it impossible to predict the specific impacts of these changes in advance. Change can either be regular or irregular in an economic system. Regular change is continuously in motion concerning public debt policies, demographics, innovation, market structures, and societal beliefs. Irregular change is an immediate shock that can take investors by surprise. Irregular shocks can often appear in commodity prices, international affairs, or in times of “irrational exuberance” to quote the words of Robert Shiller.

Security markets are sensitive to various types of risks resulting from economic change. Eugene Fama and Kenneth French gave one such example using small-cap stocks in the Journal of Finance (1993): “The fact that small firms can suffer a long earnings depression that bypasses big firms suggests that size is associated with a common risk factor that might explain the negative relation between size and average return.” On average, an investor’s return should correlate with the degree of risk being taken in an investment. When there is more risk present in the future earnings power of an investment, investors will naturally build in much higher return requirements into the security price.

There is a solution for uncertain change, however. Returns created in a diversified portfolio act to smooth out systematic uncertainty, and do a satisfactory job of consistently compensating for risk relative to that of a concentrated portfolio. Portfolio diversification is accomplished as a function of the imperfect return correlations among asset groups held in the portfolio. The rate of return that compensates for risk has a tendency to show greater robustness when risk isn’t perfectly correlated, which is an aim of portfolio diversification.

In portfolio management, return and risk are wrapped into a concept known as the Sharpe Ratio. The Sharpe Ratio acts as a measure of gained excess return in relation to the level of risk that was taken in the asset or portfolio. Excess return is the difference between risky returns and safe returns found in the income yield of US Treasuries. Sharpe Ratios of greater magnitude simply indicate that more excess return was gained on a given level of risk. This may occur more commonly for diversified portfolios relative to single asset classes, which is desirable from an investment perspective.

Recent economic changes have shed light on the variable nature of risk and return in investments. The last half-decade was notably strong in terms of performance in US large-cap investments. The first section below considers this special case and acts as a reminder that short-term experiences can change the perceptions of investors.

The next two sections make investment comparisons in two recent cycles of history and highlight the importance of portfolio diversification. Specifically, each cycle is composed of three moments in stock markets that help to capture a complete cycle: Cycles begin in (1) positive conditions that lead into, (2) negative conditions, which resume and end in (3) positive conditions. Each cycle begins 14 quarters before negative conditions set in on stock investments. The two cycles are meant to illustrate how risk and return in investments change from one cycle to the next and offer a rationale for why portfolio diversification is a valuable ingredient to successful, long-term portfolio management.

The last half-decade saw US large-caps outperform in terms of return and excess return produced on risk (Sharpe Ratio). The return and Sharpe Ratio of US large-caps rank highest in the group suggesting that performance was ahead of all other investment markets.

The remaining three, riskier assets (US small-caps, developed foreign, and emerging market), produced smaller Sharpe Ratios in comparison to US large-caps due to different premiums that were gained on risk. US small-caps and emerging markets were similar in terms of the gained excess return on risk when put in the context of Sharpe Ratio. The Sharpe Ratio of developed foreign investments was least, driven by the low return of the period. The return on emerging markets finished right behind the US large-cap return. Emerging-market risk, however, was large compared to the other investment markets. The stock market crash in China (2015) put emerging-market returns in a relatively worse position early on in the period, but a swift recovery was seen and risk was eventually recaptured by sizable returns.

Over this time period, the diversified portfolio return would have fallen below the US large-cap return. In effect, a return realized on some level of risk, in the diversified portfolio, would have more likely compared to the Sharpe Ratios of US small-caps and emerging markets, which were below the ratio of US large-caps. Looking at this information alone, it may be easy to draw faulty conclusions against portfolio diversification. Investor perception is often affected by witnessing stellar performance, such as what was recently experienced with US large-caps. This can lead to future allocations that could overconcentrate US large-cap risk. The result could harm future wealth balances if risk in US large-caps ends up being above preconceived notions. Such a small sample of evidence can create costly investment mistakes to those deciding to concentrate in one investment type based on recent experience. It is important to not underestimate all types of asset returns over broader periods of time and in full market cycles when making asset allocation decisions.

The first cycle was a time when emerging markets experienced considerable risk. Emerging markets had almost double the risk of any other investment market. Economic change was present in emerging markets following a financial crisis in Asia (1997), a devaluation of the Russian currency (1998), and a stock market crash in China (2007). Still, the return in emerging markets outperformed the returns of other investment markets. But the low Sharpe Ratio showed that a lot more risk was taken to achieve the best return of the period.US markets also had their own types of change with respect to the collapse of technology stocks (2000) and the attacks on New York and Washington D.C. (2001). These events eventually led into an 8-month recession in the US economy. 

Over the cycle, and relative to the other periods of time, risk and return were more positively correlated, which resulted in more robust Sharpe Ratios.  This is what modern portfolio theory would expect when investing with long time horizons. In other words, an adequate level of excess return was being realized in exchange for risk. Specifically, US large- and small-caps earned almost equivalent excess returns in relation to the risk of each investment market.

The Sharpe Ratios of the two foreign asset classes were below those of the US large- and small-caps. However, return correlations with large-caps were milder in the period. Therefore, portfolio diversification added value, in the period, since excess returns better matched risk and mild correlations meant returns were less synchronized. Lastly, US large-cap stocks ranked least in return, which is a departure from the experience of the last 5 years as covered in the last section. The underperformance of US large-cap stocks here shows how investment returns can and often do change with time in a single market.

The last cycle captures the global crisis of the Great Recession (2007-2009) and the recovery and expansion that came afterward. A buildup and implosion of toxic debt in the financial system led to one of the most hurtful recessions in recent memory. The European debt crisis (2010) added to prolonged and isolated global recessions as insolvent nations were in need of bailouts from solvent countries.

Developed foreign stocks ranked lowest in terms of return and the excess return gained on risk, possibly due to all of the economic change that was sweeping through the financial system at the time. The below average return on developed foreign stocks may have simply been a special case of the time. To use this period as a point of reference to set future expectations on developed foreign investments could result in an underestimation of what is possible in the future. Excess return gained on risk was fairly consistent in US large-caps, US small-caps, and emerging markets. The highest ranked return was seen in emerging markets, but it required more risk to capture the return and resulted in an average Sharpe Ratio.

US large-caps recorded the highest Sharpe Ratio. However, portfolio diversification was accomplished with non-US large-cap assets. There are several reasons as to why non-US large-cap assets are desirable in a diversified portfolio:

These comparisons of investment markets at different points in time are meant to show how sensitive risk and return are to moments of economic change. The ability to forecast change with a high degree of specificity is not sustainable nor consistently possible for any investor. One solution for managing risk resulting from economic change is to spread portfolio risk among a diverse group of investments. In such a strategy, the portfolio Sharpe Ratio may behave more consistently over long time intervals relative to investment portfolios that are concentrated.  Without portfolio diversification, investors can run the risk of mistiming investment decisions, which would can subtract from future performance.