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Evidence-Based Investment Insights: Part II



Structuring Your Portfolio

In our last installment of Financial Insights, we assessed some of the hurdles to effectively participating in efficient capital markets. Today, let’s address how to overcome the hurdles by structuring your portfolio to complement rather than combat the market forces at play. By managing the market factors you can expect to control and avoiding the temptation to react to those you cannot, you can build and sustain an evidence-based portfolio that allows the market do what it does best on your behalf: build long-term capital wealth.


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 often overlooked. Market returns are compensation for providing the financial capital that feeds the human enterprise going on all around us, all the time.


When you buy a stock or a bond, your capital is ultimately put to hard work by businesses or agencies who expect to succeed. You would think that, when a company or agency does succeed, your investment would too. But actually, such success is only one factor at best, among many others that influence your expected returns.


At first, this seems counterintuitive. It means, for example, that even if business is booming, you cannot necessarily expect to reap the rewards simply by buying its stock. Remember, by the time good or bad news is apparent, it’s already reflected in higher-priced share prices, with less room for future growth.

Market Risks and Diversification’s Rewards
So what does drive expected returns? There are a number of factors involved, but decades of academic inquiry inform us that many of the most powerful ones spring from accepting unavoidable market risks. As an investor, you can expect to be rewarded for accepting the market risks that remain after you have eliminated the avoidable ones. Let’s explain.


Avoidable Concentrated Risks Even in a bull market, one company can experience an industrial accident, causing its stock to plummet. A municipality can default on a bond even when the wider economy is thriving. A natural disaster can strike an industry or region while the rest of the world thrives. These are concentrated market risks that can be avoided by not piling all of your financial eggs into too few holdings.


Unavoidable Market Risks If concentrated risks are like bolts of lightning, market risks are encompassing downpours in which everyone gets wet. For example, invest in the market at all and, presto, you’re exposed to more market risk than if you had sat in cash (where it may lose value due to inflation, but that’s a different risk, for a different report). 


In the science of investing, we dampen avoidable, concentrated risks with diversification. By spreading your holdings widely and globally, if some of them are affected by a concentrated risk, you can offset the damage done with plenty of other unaffected holdings.


Every investor also faces market risks that cannot be “diversified away.” Those who stay invested when market risks are on the rise can expect to eventually be compensated for their steely resolve with higher returns. But they also face higher odds that results may deviate from expectations, especially in the near-term. Diversification again steps in, acting as a “dial” for reflecting the right volume of market-risk exposure you’re seeking for your individual goals.

The Essence of Evidence-Based Investing
With any risky venture, including the ones that abound in capital markets, there are no guarantees that you’ll earn hoped-for returns, or even recover your stake. This is why we so strongly favor evidence-based investing as a rational approach for staying on course toward your financial goals, especially when your emotional reactions threaten to take over the wheel.


Evidence-based investing represents the marriage between a “Who’s Who” body of scholars who have been studying financial markets since at least the 1950s, and the financial professionals who heed their findings and are tasked with an equally important charge of determining: Even if a relatively reliable return premium exists in theory, can we capture it in the real world – after the implementation and trading costs involved?


Assessing the Evidence (So Far)

In academia, rigorous research calls for more than an arbitrary sampling or a few in-house spreadsheets designed to “prove” a convenient conclusion. Academic research demands a considerably higher standard, including a disinterested, objective outlook (no foregone conclusions); robust data analysis; repeatability and reproducibility; and formal peer reviews. 


So far, this level of research has yielded five expected return premiums for patient investors:


1.     Equity – Stocks (equities) have returned more than bonds (fixed income).

2.     Small-cap – Small-company stocks have returned more than large-company stocks.

3.     Value – Value companies (with lower ratios between their stock price and various business metrics such as company earnings, sales and/or cash flow) have returned more than growth 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.

4.     Term – Bonds with distant maturities or due dates have returned more than bonds that come due quickly.

5.     Credit – Bonds with lower credit ratings (such as “junk” bonds) have returned more than bonds with higher credit ratings (such as U.S. treasury bonds).


Scholars and practitioners alike strive to determine not only that various return factors exist, but why they exist. This helps us determine whether a factor is likely to persist (so we can build it into long-term portfolios) or is more likely to disappear upon discovery. Explanations for why persistent factors linger usually fall into two broad categories: risk-related and behavioral.


Risk Returns Factors – It appears that persistent premium returns are often explained by accepting market risk (the kind that cannot be diversified away) in your portfolio. For example, it’s presumed that value stocks are riskier than growth stocks, which at least in part explains the higher expected returns they have exhibited to date.


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


Next Up, Managing the Human Factor

It’s one thing to be aware that our instinctive behaviors play a role in our investment outcomes, as described above. It’s another thing to harness that awareness to avoid the potential damage done. We’ll explore that subject in our next and final installment in this year’s Evidence-Based Investment Insights series.

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