Risk and Return are Related

Building on this and other research, Fama teamed up with Ken French and in 1992 they developed the ‘3 Factor Model’. They found that in order to generate higher returns, an investor must be willing to take higher risks. The level of risk that each person takes will depend on their own personal preferences, but it is important to distinguish between speculation and risk. Speculation in most cases involves the next ‘hot’ stock or sector and is always based on opinion.

Risk, on the other hand, is based on compensating an investor with a higher return by taking 
a higher risk. This theory is based on three well documented and researched principles.
  1. Market risk - shares are riskier than Bonds (or cash); therefore, they offer higher expected returns as a reward.
  2. Small company risk - smaller companies are riskier than larger companies; therefore, they offer a higher expected return as a result of taking this higher risk.
  3. Price risk - lower priced, or ‘value’ stocks’, which are out of favour for one reason or another offer higher expected returns compared to ‘growth’ stocks, again as there is a higher risk in investing in these stocks.
Based on this ‘three factor’ approach an investor can raise their expected return by increasing the proportion of stocks relative to bonds or cash; to small stocks relative to large stocks; and value stocks relative to growth stocks.