Alright, Dad, I think you have had a nice break since our last session (Part 1). Do you have any questions before we proceed further?
Dad: Nope, I think we are good to go forward.
Okay...! Let's move to the rather more interesting part. Today, we are going to take what we had learned in the last conversation and move our discussion towards independent risk factors and their role in forming an optimal portfolio.
But first let me ask you a question regarding discount rates, just to make sure we are on the same page..!
Tell me, if you are paying less for an asset's future profits, the implicit discount rates shall be more or less?
Dad: Let me see....If I were to pay less for any future cash flows because I think it is risky, this means my expected return going forward is higher. This further means that the discount rate that is embedded into this little framework is going to be higher.
You are absolutely right..! The less you are willing to pay, you are implicitly discounting those cash flows at a higher rate.
Dad: Yeah, I think I have understood the concept now. I might have to start using this framework while buying stocks. Do people know about this stuff? Is everybody using it out there?
Everything that I have told you now and shall be telling you in the future is already known knowledge. In fact, this idea of discounting cash flows is the bedrock of the valuation method. This is what they teach in University programs and CFA charter. I cannot speak for every individual out there but almost all of the institutional managers and millions of analysts around the world use this concept in their analysis. This analysis is called a DCF analysis (Discounted cash flow)
Hence, if you are looking at a global scale, when you are doing your DCF to come up with a figure to pay for those future cash flows, you are doing calculations along with millions of people in the market. As a matter of fact, you are competing with them on what you think is the correct value for those future profits.
Dad: I have a question. So, how can we determine risks?
Well, that is THE question dad. I am coming there.
So, as I was saying before, the millions of participants in the market competing with each other to determine how much to pay for assets determines the risk. Because note that the price paid is the function of risk. This also means, no one person can say what the right and true value is for those future cash flows. However, the aggregation of everybody's estimates regarding the price of the cash flows should determine a consensus price. AND, this final consensus price is what you see in the trading quotes, and this price finally and most importantly has an implicit discount rate embedded in it.
NOW, here come the FACTORS!
Factors kinda decompose the risk of a security (or cash flow) into different types of risks. Academic finance research has identified that there is more than 1 type of risk that is going to be included in the discount rate.
Dad: So, how many sub-risks are there?
That is a good and also a timely question considering the factor zoo that we are seeing right now. So, the main risk that any stock encompasses is the market risk. This simply means it is the risk from the entire stock market moving up and down based on a whole host of different factors and creating a risk. You can think of this as a baseline risk. If you are invested in the markets in any shape or form, you and the company you have invested in are both exposed to this risk factor.
However, depending on the features of each company, it may also be exposed to other kinds of risks that on average are actually reflected on those companies' prices. Over the years, researchers have found more than 400 factors but it has been widely accepted from the academic and practitioners community that more than 85% of those discoveries are the result of data-mining and false characterization. However, there are few that have passed the test of time. These risk premia are market, size, value, quality, and momentum.
The size risk factor is basically saying that smaller companies tend to be viewed as riskier than larger companies by the market.
Value risk suggests that less expensive companies are riskier than expensive companies. In other words, all else equal, if there are two companies with the same profits but one company is trading at a lower price compared to its book value, then this means that the market has priced an additional risk on that cheaper company.
Dad: Wait, WHY? Why is market pricing additional risks in there?
Well, the why is a bit hard to answer. We have many competing theories for that. However, right now all we can do is look at the actions of the market and observe the outcome. So, obviously, we can think of many reasons as to why this may happen. What you think is the reason or what I think is the reason might be different but there is definitely something going on. There might be management problems in the company, corruption, bad debts in books, etc. but in any case, the millions of trades in the market for this particular company are causing this stock to be priced lower, and therefore if you invest in this, you get higher expected returns.
In other words, we don't know the WHY. We just know the outcome. We know that this price is lower and that the market is deciding that this stock is riskier. The most important thing to take away from this is that the price that the market sets have information built in it. Just by looking at the price, you can tell something is going on.
The other factors namely, momentum and quality, go a bit beyond the conventional risk framework. Hence, it will take much more time for you to understand that. So, first, get the size and value factor down for now, and then, we shall talk about the rest next time.
Dad: Alright. I hope I can come up with new questions after going through my notes again.
Bivek Neupane is a recent graduate of MSc. Finance and Economics. His master’s thesis titled “Is more always better? The impact of quality in alpha and factor premia” was focused on analyzing independent risk premiums around the world. He is specializing in quantitative finance and research. If you have any questions, do not hesitate to contact him. You can connect with him via LinkedIn, his blog, or e-mail.
 For readers who are curious to know about these theories, see risk vs behavioral explanations of risk factors (https://www.msci.com/documents/1296102/1336482/Foundations_of_Factor_Investing.pdf)