If you had the ability to surpass market returns over extended periods of time, wouldn't you do it? Achieving better returns in your portfolio may be easier than you think. It has nothing to do with luck, skill or Wall Street insight. Instead, it has everything to do with portfolio construction. So, put away the darts, ignore the egocentric cocktail-party chatter and forget your hunches. The truth about exerting better control of your investment results lies just ahead.
Research, Not Intuition
Successful portfolios are based on research and reasonable expectations, not intuition. Illogical investors attempt to guess which manager, stock or asset class will have tomorrow's best performance. That's why so many have consistently failed. Successful, rational investors excel because of a clear methodology, and, of course, discipline. What type of investor are you? What type of investor do you want to be?
See: Stock-Picking Strategies
Asset allocation deals with how investors divide their portfolio among three major asset categories: cash, bonds and stocks. The asset-allocation decision, otherwise known as investment policy, is arguably the most important determinant of a portfolio's long-term return. A study by landmark Brinson, Hood and Beebower, "Determinants of Portfolio Performance" (1986, 1991) argues that investment policy accounts for 94% of the variation in returns in a portfolio, leaving market timing and stock selection to account for only 6%. (For more information, see Five Things To Know About Asset Allocation and 6 Asset Allocation Strategies That Work.)
An overwhelming amount of evidence shows that there is little advantage in attempting either to time markets or select individual equities. Such efforts instead result in additional cost, additional risk and lower returns over time.
Risk and Reward
Risk and reward are related. An investor must be induced by a potential investment return in order to give up a risk-free alternative like a Treasury bill. The same holds true for small company stock. Wouldn't you demand a greater potential return to buy a fledgling, unknown company instead of Microsoft? It's a no-brainer. There's more risk involved in the transaction, so you should demand to get paid more, right?
Investing in the equity markets can be a risky proposition. For decades, investors were only concerned with one factor, beta, in their portfolio selection. Thus, beta, the relative volatility of an asset (or portfolio) to market movements was believed to explain most of a portfolio's return. This one-factor model, otherwise known as the capital asset pricing model (CAPM), implies that there is a linear relationship between an asset's expected return and its corresponding beta. In truth, however, beta is not the only determinate of portfolio returns. Thus, CAPM has been expanded to include two other key risk factors that together better explain portfolio performance: market capitalization and book value/market value. (For more information, see Market Volatility, Weak Economy Delay Major IPOs.)
A pioneering study by renowned academics, Eugene Fama and Ken French, suggests that three risk factors: market (beta), size (market capitalization) and price (book/market value) dimensions explain 96% of historical equity performance. This model goes further than CAPM to include the fact that two particular types of stocks outperform markets on a regular basis: value stocks (high book/market value) and small caps. Although it is not clear as to why this is so, this pattern nonetheless persists in multiple time frames and every global market where we can assemble data. Below is historical data showing that between 1960 and 2004, small value (small-cap, high book/market value) stocks outperformed both the market (S&P 500) and large-value stocks. What this implies is that historically, small-value "just happens" to deliver higher returns and higher volatility than the stock market as a whole. (To learn more, see How is the value of the S&P 500 calculated?)
The Fama-French three-factor model allows investors to calculate the way portfolios take different types of risk and to calculate their expected returns. The following exhibit shows how portfolios are plotted using their risk exposures. The vertical and horizontal axes represent the exposures to value and small-cap stocks. Portfolios exposed to size risk (small-cap stocks) plot along the vertical (size) axis; and those that take risk on distressed companies (value stocks) plot on the horizontal (value) axis. Since all equity portfolios assume a market risk (beta), no additional axis is needed. Market risk is represented just below the intersection of the axes, and anything above the line is excess return above the market.
Source: Dimensional Fund Advisors
Fama and French aren't particular about why book/market value measures risk, although they and others have suggested some possible reasons. For example, high book/market values could mean a stock is distressed, temporarily selling low because future earnings look doubtful, which implies that value stocks are more risky than average - exactly the opposite of what a traditional business analyst would tell you. The business analyst would say high book/market values indicate a buying opportunity since the stock looks cheap relative to its intrinsic value. Regardless of the reasoning, there is one thing that you should take away from the three-risk-factor model - history has shown that small value stocks tend to have higher returns and higher volatility than the stock market as a whole. Thus, by carefully managing the amount of some small value stocks in your portfolio, you can achieve above-average returns. (To learn more, see How To Avoid Closing Options Below Intrinsic Value.)
Asset classes have unique cycles. When growth is doing well, value may not do as well and vice versa. In some years, small and value stocks may outperform the market; in others they may underperform. It takes resilience and psychological preparedness to endure the times they underperform. Remember, investing in small and value stocks should augment the bottom line in the long run, but investors should understand that their portfolio will not identically track the market every single year (and that's OK).
Deciding on the degree to which your portfolio should be based on the three risk factors is the challenge for the investor. Tilting toward small and value stocks will help you reach above global market returns, but portfolio risk must be tempered by adding other assets with low correlations (e.g., bonds, international stocks, international small stocks and international small value stocks).
The Bottom Line
So, what have you learned? Investors can structure portfolios that deliver above global market index returns by designing a strategic portfolio tilt. Fundamental theories like asset allocation and the three-factor model can have a dramatic impact on the way you invest.
Remember, designing a portfolio that favors small and value companies over pure market risk should deliver higher expected returns over extended periods of time. These benefits can be reliably captured by passive strategies (like index funds) that do not rely on either individual stock selection or market timing. As with many things in life, a little strategic planning goes a long way.