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

September 23, 2014
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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 bad behavior. Regardless, unfolding inquiry on market return factors continues to hone our strategies as well as identify other promising factors for most effectively capturing expected returns.

To read the next post, click here.

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