Small Value Tilting Increases Exposure To Unknown Risks?

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Park
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Small Value Tilting Increases Exposure To Unknown Risks?

Post by Park » Fri Aug 09, 2019 11:28 pm

Those who tilt to small and value make the case that such a tilt increases diversification. The argument is that the tilt increases exposure to different risks. The assumption is that just as there is risk associated with the market premium, there is also risk associated with the small and value premia. In this post, I'm not going to question that assumption.

Risks can be divided into known and unknown risks. By tilting to small and value you're diversifying exposure to known risks.

But what about diversifying exposure to unknown risks? Those who tilt might argue that the exposure to the market premium of a small cap value fund is commonly similar to that of a total stock market index fund.

But if you're investing in less than 5% of the total stock market, are you not increasing your exposure to unknown risks? I can't see how it could be otherwise. I'm far from financially sophisticated, so I welcome contrary points of view.

P.S. I tilt to value.

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Tyler Aspect
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Re: Small Value Tilting Increases Exposure To Unknown Risks?

Post by Tyler Aspect » Sat Aug 10, 2019 1:39 am

Each individual stock has its own known and unknown risks. Stocks with similar attributes might share similar risks.

Stocks with below average expectations sometimes do produce below average results. However, stocks with high expectations could fail to produce as well. It all depends on the current economic situations.

In conclusion, tilting cannot win all the time. The small cap value deficit may disappear in a few years. :shock:
Past result does not predict future performance. Mentioned investments may lose money. Contents are presented "AS IS" and any implied suitability for a particular purpose are disclaimed.

harvestbook
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Re: Small Value Tilting Increases Exposure To Unknown Risks?

Post by harvestbook » Sat Aug 10, 2019 7:13 am

My belief is that I theoretically make money on risk. This is acceptable to me, albeit risky! So it doesn't bother me, especially the stuff I don't know about, which is pretty much everything.
I'm not smart enough to know, and I can't afford to guess.

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tadamsmar
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Re: Small Value Tilting Increases Exposure To Unknown Risks?

Post by tadamsmar » Sat Aug 10, 2019 7:28 am

Park wrote:
Fri Aug 09, 2019 11:28 pm
Those who tilt to small and value make the case that such a tilt increases diversification. The argument is that the tilt increases exposure to different risks. The assumption is that just as there is risk associated with the market premium, there is also risk associated with the small and value premia. In this post, I'm not going to question that assumption.

Risks can be divided into known and unknown risks. By tilting to small and value you're diversifying exposure to known risks.

But what about diversifying exposure to unknown risks? Those who tilt might argue that the exposure to the market premium of a small cap value fund is commonly similar to that of a total stock market index fund.

But if you're investing in less than 5% of the total stock market, are you not increasing your exposure to unknown risks? I can't see how it could be otherwise. I'm far from financially sophisticated, so I welcome contrary points of view.

P.S. I tilt to value.
I think it is called hidden risk. Risk that doesn't show up in the historical standard deviation of the stock, so the stock appears to have a relatively high risk-adjusted return. On this theory, if you tilt then you are increasing your exposure to hidden risk. That sounds bad, but it's not bad if you are getting compensated for it, it could be neutral.

The source of the risk is not necessarily unknown. And we don't always know the source of large-cap volatility either.

And that is only one theory of the source of the relatively high risk-adjusted return.

heyyou
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Re: Small Value Tilting Increases Exposure To Unknown Risks?

Post by heyyou » Sat Aug 10, 2019 10:39 pm

I know that I do not know, so I try to keep equal slices of many stock asset sub-classes, as seen on the Callan Periodic Table.
I agree with harvestbrook, so I am not seeking certainty about any facet of allocating. Good enough has worked well so far, and that too, is a subjective matter/opinion.
by harvestbook »
My belief is that I theoretically make money on risk. This is acceptable to me, albeit risky! So it doesn't bother me, especially the stuff I don't know about, which is pretty much everything.
If Small Value sometimes pays more, most assuredly there is more risk of it not paying more when we mere investors want it to do so. Embrace the uncertainty and randomness, since they are what we have. Good luck to others seeking to quantify and categorize the precise risks of SCV, since there will probably be just one more risk that appears unexpectedly at the most inopportune time.

Psst, here is a gold plated investing tip: Just spend less to save and invest more, since those will also increase your portfolio value over long periods.

dardeninvestor
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Re: Small Value Tilting Increases Exposure To Unknown Risks?

Post by dardeninvestor » Sat Aug 10, 2019 10:48 pm

The risks are known. Small value tilting increases return but also risk, probably not along a normal distribution, and thus out of proportion to return. High tail risk that only manifests itself during extreme events. Hence why Citigroup was largest holding of the fundamental investing index when the market crashed in 2008.

Marginally higher return for a lot of risk when the world is crashing.

Pepper11
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Re: Small Value Tilting Increases Exposure To Unknown Risks?

Post by Pepper11 » Sat Aug 10, 2019 11:17 pm

I was tilting small value and it was a terrible drag on the portfolio. Switched the tilt to large growth and things are much nicer.

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Tyler Aspect
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Re: Small Value Tilting Increases Exposure To Unknown Risks?

Post by Tyler Aspect » Sun Aug 11, 2019 1:23 am

Pepper11 wrote:
Sat Aug 10, 2019 11:17 pm
I was tilting small value and it was a terrible drag on the portfolio. Switched the tilt to large growth and things are much nicer.
Be careful about chasing returns. You never know when these style trends will shift in and out of favor.
Past result does not predict future performance. Mentioned investments may lose money. Contents are presented "AS IS" and any implied suitability for a particular purpose are disclaimed.

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