Risk and Return are related: Ownership, Company Size, Market Price, and Profitability Matter
by Randall J. Cloud
Academic researchers have found that portfolio returns are driven by the percentage of investment that the portfolio has in certain groups of companies.
Companies can be categorized into groups based on 1) their offer to us to be an owner or lender to them, 2) their size, 3) the price of their stock, and 4) profitability.
The tradeoff for higher returns is that investors must accept greater volatility or change in market value from month to month and year to year.
Market Premium: Stocks outperform Bonds
Being an investor in a company (owning their stock) rather than being a lender (owning their bonds) to a company provides greater investment returns over time.Size Premium: Small Companies outperform Large Companies
Small companies as a group outperform large companies as a group from an investment standpoint over time. Using a banking analogy, who presents more risk generally speaking to a banker of not repaying a loan? The small company is less likely to repay so the banker demands a higher return by charging a higher rate of interest.Value Premium: Lower Price Companies outperform Higher Price Companies
Value Companies as a group outperform Growth Companies as a group from an investment standpoint over time.
Value companies are ones whose stock prices are depressed and out of favor with the public. We can buy these companies at deeply discounted prices.
Profitability Premium: Higher Profit Margin outperform Lower Profit Margin
Whether companies are large or small, lower price or higher price, U.S. or International, those who are more profitable provide greater investment returns over time.