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Key Investment Insights: Factors That Influence Your Evidence-Based Portfolio

September 23, 2014

Welcome to the next installment in our Key Investment Insights series. In our last piece, we explored what we mean by “evidence-based investing.

Grounding your investment strategy in a rational methodology strengthens your ability to stay on course toward your financial goals. In order to reach those goals we must first:

  1. Assess the expected returns, given the capacities and limitations of the existing factors;
  2. Understand why such factors exist, so that we can more effectively apply them; and
  3. Explore additional factors that could complement our structured approach.

Assessing the Evidence, Thus Far

Numerous studies which date back to the 1950s have resulted in the identification of three stock market factors which form the basis for evidence-based portfolio construction over the long-term:

  1. The equity premium – Stocks (equities) have returned more than bonds (fixed income).
  2. The small-cap premium – Small-company stocks have returned more than large-company stocks.
  3. The value premium – Value companies are defined as those companies with lower ratios between their stock price and various business metrics (e.g. company earnings, sales and/or cash flow.  They have returned more than so-called growth companies (defined as those companies with higher such ratios). These are stocks that, based on the empirical evidence, appear to be either undervalued or more fairly valued by the market, compared with their growth stock counterparts. 

If you have ever heard financial professionals talking about the “three-factor model,” this is the trio involved. Similarly, academic inquiry has identified two primary factors which drive bond (fixed income) returns:

  1. Term premium – Bonds with distant maturities or due dates have returned more than bonds that come due quickly.
  2. Credit premium – Bonds with lower credit ratings, such as “junk” bonds, have returned more than bonds with higher credit ratings, such as U.S. Treasuries.
      • Three-Factors (1)    

You can click on the graph for a better view.  Then click back to continue reading.

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Understanding the Evidence

Scholars and practitioners make every effort first to determine that various return factors do, in fact, exist, and then determine why that is so. This, in turn, helps us determine whether a factor is likely to persist (so that we can build it into a long-term portfolio) or if it is more likely to disappear upon discovery.

Explanations as to why some factors persist fall into two broad categories: risk-related and behavioral.

A Tale of Risks and Expected Rewards

Persistent premium returns are often explained by accepting market risk (i.e. the kind that cannot be diversified away) in exchange for expected reward.

For example, value stocks are presumed riskier than growth stocks. In “Do Value Stocks Outperform Growth Stocks?” columnist Larry Swedroe explains: “Value companies are typically more leveraged (have higher debt-to-equity ratios); have higher operating leverage (making them more susceptible to recessions); have higher volatility of dividends; and have more ‘irreversible’ capital (more difficulty cutting expenses during recessions).”

A Tale of Behavioral Instincts

There may also be behavioral foibles at play. That is, our basic-survival instincts often overshadow otherwise well-reasoned financial decisions. As such, the market may favor those investors who are better at overcoming their impulsive, often damaging gut reactions to breaking news.

Your Takeaway

Factors that figure into market returns may be a result of taking on added risk and/or avoiding the self-inflicted wounds of behavioral temptations. Regardless, existing and unfolding inquiry on market return factors continues to hone our strategies as well as identify other promising factors for most effectively capturing expected returns according to your personal goals.

Key Investment Insights: The Essence of Evidence-Based Investing

September 17, 2014

Welcome to the next installment in our series of Key Investment Insights. In our last piece, “What Drives Market Returns?” we explored how markets deliver wealth to those who invest their financial capital in human enterprise. But, as with any risky venture, there are no guarantees; no guarantee that you’ll earn the returns that you’re aiming or hoping for, and no guarantee that you’ll even recover your original stake. This leads us to why we so strongly favor evidence-based investing. Grounding your strategy in rational methodology can help you stay on course toward your financial goals.

So what does evidence-based investing entail?

Market Return Factors: The Essence of Evidence-Based Investing

Over the last five decades, a “Who’s Who” body of scholars has been studying financial markets in order to answer investors’ most pressing questions, including:

  • What drives returns? Which return-yielding factors appear to be persistent over time, around the world and across a range of market conditions?
  • How does it work? Once identified, can we explain why particular return-yielding factors exist, or at least narrow it down to the most likely causes?

Financial Scholar vs. Financial Professional

Building on this academic inquiry, fund companies and other financial professionals have an equally important task: Even if a relatively reliable return premium does theoretically exist, can we capture it in the real world – after the implementation and trading costs involved?

As in any discipline, from finance to biology, it’s in academic researchers’ interest to discover the possibilities and it’s in our interest to figure out what to do with that understanding. This is, in part, why it’s important to maintain the separate roles of financial scholar and financial practitioner, to ensure that each of us is doing what we can do best.

The Rigors of Academic Inquiry

In academia, rigorous research typically demands:

A Disinterested Outlook – There should be no hidden agenda, other than to explore intriguing phenomena and report the results.

Robust Data Analysis – The analysis should be free from weaknesses such as:

  • “Suspect” data, i.e. data that is too short-term, too small a sampling or otherwise tainted.
  • “Survivorship bias,” in which the returns from funds that were closed during the study are omitted from the results.
  • Apples to oranges comparison, i.e. using an inappropriate benchmark against which to assess a fund’s or strategy’s “success” or “failure.”
  • Insufficient use of advanced mathematics like multi-factor regression, which helps pinpoint the critical factors from among myriad possibilities.

Repeatability and Reproducibility – Results must be repeatable and reproducible by the author and others, across multiple, comparable environments. This strengthens the reliability of the results and helps to ensure the outcomes weren’t just random luck.

Peer Review – Last, but hardly least, scholars must publish their detailed results and methodology, typically within an appropriate academic journal, so similarly credentialed peers can review their work and agree that the results are sound or rebut them with counterpoints.

Your Takeaway

As is the case in any healthy scholarly environment, those contributing to the lively inquiry about what drives market returns are rarely of one mind. Still, when backed by solid methodology and credible consensus, an evidence-based approach to investing offers the best opportunity to advance and apply well-supported findings in order to strengthen the ability to build and/or preserve long-term personal wealth according to your unique goals.

Next, we’ll further explore market factors and expected returns. 

Key Investment Insights: What Drives Market Returns?

September 11, 2014

Welcome to the next installment in our series of Key Investment Insights.

In our last piece, “Smoothing the Investment Ride,” we discussed the benefits of diversifying your investments to minimize avoidable risks, manage the unavoidable ones that are expected to generate market returns, and better tolerate market volatility. The next step is to understand how to build your diversified portfolio to effectively capture those expected returns. This in turn calls for some understanding of how those returns are generated.

The Business of Investing

With all the excitement over stocks and bonds and their ups and downs in headline news, there is a key concept that is often overlooked: Market returns are investors’ compensation for providing the financial capital which feeds human enterprise.

Simply put, whenever you buy a stock or a bond, your capital is put to work, either by a business or an agency whose management expects to succeed at whatever task it is that they have set out to accomplish, i.e., grow oranges, sell virtual cloud storage, build a dam or run a hospital. You, as an investor, are not giving your money away; no, you expect to receive your capital back, and then some.

Investor Returns vs. Company Profits

A company hopes to generate profits while a government agency hopes to complete its work. Consequently, investors hope to earn generous returns. You might assume that if a company or agency succeeds, that its investors would, too. In actuality, a company’s or agency’s success is but one factor among many others which can influence its investors’ expected returns.

In terms of an equity investment, that might seem counterintuitive, because you’d expect to be rewarded if a company’s business is booming. The simple fact, as we’ve said before, is that anticipated good (or bad) news has, for the most part, already been priced in by the market and reflected in higher-priced shares, meaning that there’s less room for future price growth.

The Facts about Market Returns

So what does drive expected returns? There are a number of factors involved, but some of the more powerful ones tend to spring from the unavoidable market risks we had introduced earlier. As an investor, you can expect to be rewarded for accepting the market risks which remain after you have diversified away the avoidable, concentrated ones.

Consider two of the broadest market factors: stocks (equities) and bonds (fixed income). Most investors start by deciding what percentage of their portfolio to allocate to each. Regardless of the split, you are still expecting to be compensated for all of the capital you have put to work in the market. So why does the allocation matter?

When you buy a stock …

  • You become a co-owner in the business, with voting rights at shareholder meetings.
  • Your returns come from increased share prices and/or dividends.
  • If a company goes bankrupt, you are nearer the end of the line of creditors to be repaid.

When you buy a bond …

  • You are lending money to a business or government agency, and have no ownership stake.
  • Your returns come from interest paid on your loan/investment.
  • If a business or agency defaults on its bond, you are nearer to the front of the line of creditors to be repaid with any remaining capital.

In short, bond holders are more likely to receive a positive return compared to stock owners. Of course, there are exceptions to this; a “junk” bond in a dicey venture or a public agency with a less than stellar credit rating may well be riskier than a share of a blue-chip stock. Generally, however, stocks are considered riskier than bonds and, as a result, have generally delivered higher returns than bonds, over time.

This outperformance of stocks is called the equity premium. The precise amount of the premium and how long it takes to be realized is far from a sure bet; that’s where the risk comes in. But, viewing stock-versus-bond performance in a line chart over time, it’s easy to see that stock returns have handily pulled ahead of bonds over the long-run … but have also exhibited a bumpier ride along the way. Higher risks AND higher returns show up in the results.

DFA Investment Principles Slide 3

 

 

 

 

 

 

 

 

 

 

 

You can click on the graph for a better view.  Then click back to continue reading.

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Your Takeaway

Exposure to market risk has long been among the most important factors contributing to premium returns. At the same time, ongoing academic inquiry indicates that there are additional factors which contribute to premium returns, some of which may be driven by behaviors other than risk tolerance. In our next Key Investment Insight, we’ll continue to explore market factors and expected returns, and why our evidence-based approach is so critical to that exploration.