A basic principle of investing is that there is no return without risk. In other words, if you want higher returns, you must accept higher risk.
But taking more risk does not necessarily mean higher returns. Driving without a seatbelt, for example, adds risk for little additional benefit.
So an investor wishing to achieve the optimal balance of risk and return must measure and manage risk.
Limiting volatility and loss
Mitigating risk starts with diversification by spreading portfolio exposure across multiple non-correlated sectors. This is among the most effective safeguards against volatility and investment risk.
Other risk management approaches limit the potential downside, such as a stop-loss limit (automatically closing a position when losses exceed a certain threshold) or a position limit (restricting the percentage weight of an investment in a portfolio to a certain level).
You can also plan your risk exposure in various ways. Risk budgeting allocates a fixed amount of risk across portfolios. Stress testing simulates the potential loss under a given set of scenarios. More sophisticated methodologies such as Value at Risk (VaR) incorporate the lens of probability and simulation.
Approaches to active investing
Diversification and risk management limit loss. But how does an active investor achieve above-average returns?
Active investors face an ongoing debate between growth and value investing.
- Growth stocks are companies are expected to achieve rapid growth in earnings (recent examples might be Zoom, Tesla)
- Value stocks are mature firms with strong underlying fundamentals but undervalued based on common performance measures (e.g. General Motors, Procter & Gamble).
Growth vs Value
So, which is riskier: growth or value? The short answer is that it all depends on the stock. The promised growth of Growth Stock X may not materialize, and the fundamentals of Value Stock Y may not be strong enough to manage adverse scenarios.
It also depends on the time period and the time horizon.
This chart shows a general downward trend in U.S. 10-year treasury yields, the benchmark for risk-free borrowing, from 2008 to 2020.
Firms that promise rapid growth (i.e. Growth stocks) benefit when interest rates and inflation while established firms (i.e. Value stocks) underperform despite their stable growth.
The reverse applies during rising interest rates and inflation, such as from 2020 to 2022.
The reason is that higher interest rates will discount future growth more heavily the further it lies in the future, disadvantaging Growth stocks, while established Value stocks deliver higher near-term returns that are less affected by future discounting.
Case Study: ARK Innovation and Berkshire Hathaway
Below are the sector allocation for two investment funds. ARK Innovation ETF, managed by Cathie Wood, and Berkshire Hathaway, run by Warren Buffet.
ARK Innovation ETF is a growth-focused fund. Its assets are more concentrated, especially in the highly correlated Technology and Communication Services. In other words, they are less diversified and more exposed to the target sectors.
Berkshire Hathaway has famously championed the value-focused investing approach. While it appears to be heavily exposed to the technology sector (49.26%), the investments are mainly mature firms such as Amazon and Apple.
Most ARK companies have negative earnings per share (EPS), which is common for growth stocks as they spend significant capital to finance their growth. Meanwhile, nearly all the Berkshire portfolio companies have positive EPS.
Sales multiples, or price to sales (P/S) tell a similar story. Companies in the ARK portfolio trade at 15.0 times annual sales (in expectation of rapid sales growth), while Berkshire portfolio companies trade at 4.1 times annual sales.
The Tortoise and the Hare: an Updated Fable
Applying the logic above, ARK Innovation should have performed less well overall than Berkshire Hathaway as interest rates and inflation have risen lately.
The above chart shows that ARK achieved outstanding growth of 200% in 2020 and early 2021, due largely to its heavy exposure to technology and communication providers, whose business thrived during the pandemic.
But as interest rates rose in 2021 (see Treasury Yields chart above), the performance of ARK declined while that of Berkshire increased steadily. As of April 2022, ARK had achieved total growth of just 7.43%, compared to 48.2% for Berkshire, with twice the volatility.
In identifying promising investments, a prudent investor should also evaluate how investment types (such as growth vs. value) perform over the market cycle phases.
The above illustrate the respective pros and cons of the two strategies. A focus on growth may achieve stellar returns for a certain time, but rapid growth is hard to sustain when the market environment changes.
At The Family Office, we prefer steady returns over the long term to high short-term returns that carry increased risk and volatility.
In the words of the ancient fable, “Slow and steady wins the race.”