Over the last fifty years, evidence from practising investors, financial economists and leading academics alike points to an undeniable conclusion: risk and return are related. They have provided us with the understanding that taking a chance may result in a gain, but not all risk-taking is rewarded. Everything known about expected returns in equity markets can be summarised in three dimensions:
- Stocks are riskier than bonds and have greater expected long-term returns.
- Small company shares have higher expected returns than large company shares.
- Lower-priced value shares have higher expected returns than higher priced growth shares.
Many economists believe that small company and value stocks outperform over the long term because the market discounts their prices to reflect the underlying risk. The lower prices give investors greater upside as compensation for bearing this risk. Shorter-term, high-quality debt instruments such as bonds have less risk, and this fixed interest is primarily used as a strategy to maximise overall portfolio benefit. Magus designs portfolios and uses lower-risk bond strategies to alleviate the total portfolio volatility, or uses more equities where expected returns are greater.