Academic research has identified specific equity and fixed income dimensions, which point to differences in expected returns. Investors can pursue higher expected returns by structuring their portfolio around these dimensions, also referred to as “premiums.”
Another core investment belief is that risk and return are related, and thus, inseparable. In the capital markets, there is no free lunch. Investors who want to earn higher expected returns must accept higher levels of risk. But not all risks are worth taking. Some risks offer an expected reward to investors who are willing to bear them, while others do not.
Investment risk can be measured many ways, including the possibility of the fluctuation or loss in capital value. Every stock carries two types of general risk.
The first is specific risk, also known as unsystematic risk. This risk embodies the possibility that certain isolated events within a company or industry may affect that company’s future profitability and stock price. Since this risk is limited to a particular firm or sector, it does not impact all companies throughout the economy. Specific risk can be reduced through proper diversification in a portfolio. This risk is also known as diversifiable, uncompensated, and idiosyncratic risk. Investors are not paid an expected return to bear this risk because it can be managed through diversification.
Systematic risk is the risk inherent in the market. It reflects macroeconomic conditions affecting all companies in the stock market or asset class. This risk cannot be diversified away, and investors receive an expected return as compensation for bearing it. This risk is also known as nonspecific risk and compensated risk. Robust sources of higher expected returns are compensation for bearing systematic risks.
Rather than viewing the market universe in terms of individual stocks and bonds, investors should define the market along the dimensions of expected returns to identify broader areas or groups that have similar relevant characteristics.
This approach relies on academic research and internal testing to identify these dimensions, which point to differences in expected returns.
In the equity market, the dimensions are size (small cap vs. large cap), relative price (value vs. growth), and profitability (high vs. low). In the fixed income market, these dimensions are term and credit quality. The return differences between stocks and bonds can be considerably large, as can the return differences among a group of stocks or bonds.
To be considered a dimension, it must be sensible, backed by data over time and across markets, and cost-effective to capture in diversified portfolios.
In a dimensions-based approach, capturing returns does not involve predicting which stocks, bonds, or market areas are going to outperform in the future. Rather, the goal is to hold well-diversified portfolios that emphasize dimensions of higher expected returns, control costs, and have low turnover.