Why the biggest risk to equity portfolios is the equity market


Nov. 21 2019, Updated 4:48 p.m. ET

Risk factor #1: Market risk in a rising rate environment—the biggest risk of all

Given the announcement of the Federal Reserve Bank to potentially end its bond buying program by the end of this year, it’s important for investors to know how this development could impact their portfolio—whether they be value versus growth investors, or large cap versus small cap investors, or even momentum-based traders. This series examines the main four factors that determine your portfolio’s performance:

  1. The overall return of the stock market (market risk)
  2. The size of the companies you invest in (large versus small companies)
  3. The price-to-book ratio of the companies you invest in (value versus growth stocks)
  4. The positive or negative momentum of the stocks you invest in
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We’ll also examine the relative performance of these factors over time and look at specific companies to illustrate the implications of these investment factors in determining specific equity and portfolio returns. Given potential changes in the interest rate environment, it will be important for investors to take a look at how their investments have been allocated across the four sectors noted above, as the investment return vary widely between these four factors. An interest rate spike could send a shock through the financial system, and strategic investing can mitigate risks.

For an overview on these four risk factors, please see Key strategy: 4 key risk factors as the Fed tapers.

The S&P 500—The market itself accounts for 70% of your portfolio’s returns

The above graph reflects a simple graph of the most commonly referenced and traded broad market index—the Standard and Poor’s 500 Index, or S&P500 (SPY). This article explains the role of market risk in determining your stock portfolio’s returns.

Market risk is the biggest—70%

Approximately 70% of a portfolio’s return is determined by the overall return of the stock market alone. In other words, as goes the S&P 500, so goes your portfolio. This idea is explained by the Capital Asset Pricing Model, known as “CAPM.” This model essentially states that your portfolio’s returns are directly related to the S&P 500 Index, though they’ll vary from this index based on how risky your particular portfolio stocks are relative to the S&P 500. If your stocks are twice as “risky” (volatile) as the stocks in the S&P 500, they’ll go up or down roughly twice as much as the S&P 500. This relationship accounts for roughly 70% of your portfolio’s returns. Simply put, the riskier (more volatile) your portfolio is relative to the S&P 500, the more you stand to gain or lose relative to the S&P500.

Factor #1: Beta—How risky your portfolio is relative to the S&P 500

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The academics refer to this idea as “beta.” If your portfolio is twice as risky as the S&P 500, your portfolio has a beta of 2. If your portfolio is half as risky as the S&P 500, your portfolio has a beta of 0.5. The S&P 500 is the benchmark against which everything is compared, and accordingly, it’s assigned a benchmark beta of 1.0.

Factors #2 and #3: Market cap and price—90%

The academics suggest that 90% of your portfolio returns are a function of three factors:

  1. Your market risk exposure—the “beta” or riskiness of your profile relative to the overall market index, the S&P 500
  2. Market capitalization: The extent to which your portfolio holds large market cap stocks versus small market cap stocks (big versus small companies)
  3. The price-to-book ratio: The extent to which your own high price to book stocks—growth stocks—versus low price to book stocks—value stocks

Factor #4: Momentum

Much interest has developed around momentum investing—chasing the skyrocketing shares of Keurig Green Mountain (GMCR) or Lululemon Athletica (LULU). Adding in momentum as a fourth factor to explain the returns of a portfolio, as noted above, adds little to the ability to explain the returns of your portfolio. While day trading stocks with great positive or negative momentum may be attractive to day traders, the academic research suggests that the addition of this fourth factor as a variable to explain portfolio returns really doesn’t add any meaningful incremental explanatory power over the prior three factors noted earlier. In other words, the three factors noted earlier, or the Fama-French Three Factor Model, are sufficient to structure your portfolio, and the fourth factor, momentum, may not provide much additional explanatory power—the Carhart Four Factor Model.


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As the above graph reflects, overall market returns can vary widely. The average return for the S&P 500 from December 1929 through December 2013 may be 7.13%, but the annual return can be as high as +45% or as low s -47%. The above graph notes that the standard deviation of the annual return is 19.30%, which is a measure of volatility off the S&P 500. This particular data is inflated by very old and very new data, which was extremely volatile. Barring such extreme observations of volatility, the more normal range for S&P volatility is probably closer to around 15%, which traders consider more normal average levels of how much the S&P 500 could go up or down in a given year.

To see why the Russell 2000 index outperforms the S&P 500 and Dow Jones index, please see the next article in this series.

Equity outlook: Constructive macro view

Despite problems in Ukraine and China, and despite the modest consumption data in the USA, U.S. labor markets appear to be well into recovery—with the exception of the long-term unemployed. From this perspective, it would appear that the U.S. is probably the most attractive major investment market at the moment. While the fixed investment environment of the U.S. is still quite poor, corporate profits and household net worth have hit record levels. Hopefully, all of this wealth and liquidity can find their way into a new wave of profitable investment opportunities and significantly augment the improvement in the current economic recovery. For investors who see a virtuous cycle of employment, consumption and investment in the works, the continued outperformance of growth stocks over value stocks could remain the prevailing trend, favoring the iShares Russell 1000 Growth Index (IWF) and growth-oriented companies such as Google (GOOG) or Apple (AAPL).

Equity outlook: Cautious macro view

Given the China- and Russia-related uncertainties, investors may wish to consider limiting excessive exposure to broad equity markets, as reflected in the iShares Russell 2000 Index (IWM), the State Street Global Advisors S&P 500 SPDR (SPY), the Dow Jones SPDRs (DIA), and the iShares S&P 500 (IVV). Accordingly, investors may wish to consider shifting equity exposure to more defensive consumer staples–related shares, as reflected in the iShares Russell 1000 Value Index (IWD), such as Walmart (WMT).


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