Key Investment Insights: What Drives Market Returns?

September 11, 2014
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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.

 

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