Risk equals reward, right?

This has been an investment concept for more than a century. The notion implies that every asset class delivers gains that account for their volatility and risk.

Bonds (which have default risk) generate modestly better returns than cash, large-cap stocks have delivered better returns than bonds over the long haul, and small-cap stocks, the riskiest asset class of all, are expected to generate the best returns of all, at least for investors who can stomach the wild swings.

But is the adage really true? Are you really compensated for risk with better returns?

The answer may surprise you.

To see whether you are taking on too much risk in search of rewards, let’s turn to Stanford University professor William Sharpe, who devised a handy measure of risk-adjusted returns back in the 1960s. His “Sharpe ratio” is used by many academic as they delve into this contentious issue. The Sharpe ratio tells investors how much return they should expect for the risks they are taking.#-ad_banner-#

If you have a keen head for math and want to see the formal mathematical equation of the Sharpe ratio, then here it is:

(Rp – Rf ) / Sp

There are other, more complex formulas, but all of them entail the expected return of a risky asset (Rp) minus the expected return of a risk-free asset (Rf) such as a bond, divided by the standard deviation (Sp) of the risky asset.

OK, we’re getting stuck in jargon here, so let’s keep it simple, and take a look at how various kinds of stocks have performed, relative to the risk that they represent.

Conveniently, economists at the American Association of Individual Investors (AAII) took a look at small-cap, mid-cap and large-cap stocks in an unusually volatile period, from January 2008 through July 2012. And they found largely what you would expect: Smaller stocks are riskier and more volatile.

But the story doesn’t end there. Sure, they’re riskier — but what about the reward?

Well, it turns out that even after adjusting for risk (using the formula above) the better returns of smaller stock were still worth the trouble.

“Although the S&P SmallCap 600 is more volatile and thus riskier, holders of the index were much better compensated for the risk compared to holders of the S&P 500 during that period,” was their key conclusion.

This conclusion flies in the face of what many investors believe. “Small stocks are just too risky and not worth the trouble,” you’ll hear many people say. But studies have shown that the riskier the asset, the higher the returns, at least over the long haul.

To be sure, a portfolio comprising only small-cap stocks makes little sense. Small caps tend to move as a herd and can generate several years’ worth of underperformance if the broader market is in the mood to favor large caps and bonds. A nice blend of all of these assets is the way to go.

Frankly, trying to calculate the Sharpe ratio for your stocks is tricky, as a small sample size of just a few dozen stocks may skew the denominator (standard deviation), rendering the results moot. That’s why investors more often use Sharpe ratios when assessing the performance of hedge funds, mutual funds and exchange-traded funds (ETFs). These funds hold many different stocks year after year, thus creating a more meaningful set of figures to use.

Action to Take–> Your goal is to neither embrace nor shun risk. It’s crucial that you hold some conservative investments in your portfolio so you can sleep well at night. But a portfolio with too much of a conservative tilt (such as only bonds and blue-chip stocks, for example) may prevent you from building a large enough portfolio that you can eventually rely upon in retirement.

This article originally appeared at InvestingAnswers.com
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