The Three Factor Model
There are many types of investment risk, but the one forefront in the minds of most investors is market risk, which is the risk that the market as a whole will fall in value, dragging the value of our investments with it. We who participate in the equities markets for the potential excellent long-run returns pay the price by suffering through bear markets. In about one out of four years we experience a bear (down) market, so it is plain that these tough times are as common as dirt.
Most investors loathe bear markets. We say "learn to love them". If it weren't for the unpredictability of equity prices, we would not have obtained the excellent long-run returns we have. This return that we get in return for market risk is called the equity risk premium. Think of it this way: many investors sell their equities out of fear, driving their price down, which in turn allows you to buy them at reduced prices, thus increasing your ultimate return. Here is my favorite definition of a bear market: "A period of time in which short term investors return stocks to their rightful owners".
Another type of risk is often referred to as the size effect. It has been often noted that small cap stocks are more risky than large caps. This makes intuitive sense: a fledgling company may be undercapitalized or unproven. Growth may be dramatic, but catastrophe is always just a few bad decisions away. A new government regulation, a new tax, a lawsuit, a downturn in demand or successful competing product or service; any of these things can be more devastating to a small company than a large one. We see this heightened risk in the more volatile stock prices of small caps.
But as is true with market risk, we see increased returns with small caps. The CRSP database is the most reliable record of historical US stock returns. According to the CRSP database, between 1926 and 2010 U.S. Small Caps have had an average annual return of 12%, whereas the S&P 500 which is a good proxy for large caps has returned 9.9%. This is a very significant difference when compounded over 84 years!
A third type of risk can be referred to as the price effect. This one is a bit counterintuitive and thus more difficult to grasp. A company that is perceived to be excellent will command a higher market price than a distressed company. It is quite shocking to discover that returns on distressed companies have historically exceeded the returns on excellent companies!
So we have three dimensions of risk that historically have enhanced returns:
Although we would like to take credit for this knowledge, it must be given where it is due: to Eugene Fama who developed the random walk theory and the efficient markets hypothesis, along with his colleague Kenneth French. Together they developed the Fama–French three-factor model, which identified the three dimensions of risk above, and demonstrated that they increase expected returns.
We exploit these three dimensions of risk and avoid risks that are not expected to increase returns. For example, concentrating a portfolio into one or a handful of investments is highly risky, but there is no commensurate increase in expected return. Therefore we massively diversify our investment holdings.