Risk/Return

Investors are rewarded in proportion to the risk they take. Framing decisions around compensated risk factors in the equity and bond markets connects investors to the forces that create opportunities to build wealth over time.

Evidence from practicing investors and academics alike points to an undeniable conclusion: Returns come from risk. Gain is rarely accomplished without taking a chance, but not all risks carry a reliable reward. Capital market research over the last fifty years has brought us to a powerful understanding of the risks that are worth taking and the risks that are not.

Three Equity Factors

Much of what we have learned about expected returns in the equity markets can be summarized in three dimensions. The first is that stocks are riskier than bonds and have greater expected returns. Relative performance among stocks is largely driven by the two other dimensions: small/large and value/growth. Many economists believe small cap and value stocks outperform because the market rationally discounts their prices to reflect underlying risk. The lower prices give investors greater upside as compensation for bearing this risk.

Size and Value Matter

In US dollars. Developed markets value and growth index data provided by Fama/French (ex utilities). The S&P data are provided by Standard & Poor's Index Services Group. US Small Cap Index is the CRSP 6-10 Index. CRSP data provided by the Center for Research in Security Prices, University of Chicago. International Small Cap index data: 1970–June 1981, 50% UK small cap stocks provided by the London Business School and 50% Japan small cap stocks provided by Nomura Securities; July 1981–present: simulated by Dimensional from StyleResearch securities data; includes securities of MSCI EAFE Index countries, market-capitalization weighted, each country capped at 50%. MSCI EAFE Index is gross of foreign withholding taxes on dividends; copyright MSCI 2012, all rights reserved.

Indexes are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Compound returns have an assumed rate of return, are hypothetical, and are not representative of any specific type of investment. Standard deviation is one method of measuring risk and performance, and is presented as an approximation. Past performance is no guarantee of future results.

Fixed Income Factors

Relative performance in fixed income is largely driven by two dimensions: term and credit. Longer-term bonds are subject to the risk of unexpected changes in interest rates. Bonds with lower credit quality are subject to the risk of default. Extending bond maturities and reducing credit quality increases potential returns.

Fixed Income Factors: Global Indices

In US dollars. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results.

Maturity Factor: Short-Term Government is BofA Merrill Lynch One-Year US Treasury Note Index; Intermediate-Term Government is Barclays Capital US Government Bond Index Intermediate; Long-Term Government is Barclays Capital US Government Bond Index. Credit Factor: Short-Term Government is Barclays Capital US Government Index 1-3 Years; Short-Term Credit is Barclays Capital 1-3 Year Credit Index; Intermediate-Term Government is Barclays Capital US Government Bond Index Intermediate; Intermediate-Term Credit is Barclays Capital Credit Bond Index Intermediate. Global: Short-Term Government is Citigroup World Government Bond Index 1-3 Years (hedged); Med-Term Government is Citigroup World Government Bond Index 1-5 Years (hedged); Long-Term Government is Citigroup World Government Bond Index 1-30+ Years (hedged).

Sources: Barclays Capital data provided by Barclays Bank PLC; the Merrill Lynch Indices are used with permission; copyright 2011 Merrill Lynch, Pierce, Fenner & Smith Incorporated; all rights reserved.