It’s the most sought after information in the investment world: where do returns come from?
“Expected return” represents the reward an investor can expect for the level of risk they’re willing to take. In truth, the pursuit of expected return really isn’t a search for return itself, but rather the reliable information that helps us to understand what determines it. The journey begins at the intersection of technology and financial science.
Thanks to technology’s evolutionary ability to harness massive amounts of data, we know more today than we ever have. With so many ways to evaluate any particular company, the question is: which factors matter most, and which provide the most credible evidence across time, geography and asset class?
The objective approach that financial science takes turns a blind eye to the name or even the reputation of any one company. It only cares about the search for reliable information that’s too concrete to dismiss. Over the last 60 years we’ve learned a lot about factors that influence expected return. Research has shown that over 90% of a diversified portfolio’s returns can be explained by its exposure to the market as a whole, to the relative size of the companies within the portfolio, and to their current market trading prices relative to the book value of all their assets.
Where Do Returns Come From?
Let’s break that down. Why do these factors help us understand where expected return comes from? Start with this simple premise. There are two primary ways to invest in any stock exchange-listed company. Buy equity (stock), or buy debt (bonds). Basically, both are loans where investors supply a company with capital. Your incentive lies with the belief that a return on investment is probable. The tradeoff is your acceptance of risk, for the chosen company’s acceptance of funding. (For more, see: How to Calculate Your Investment Return.)
Exposure to the market: So why are stocks riskier than bonds? Bond holders have priority claims at dissolution over stocks. All that means is if a company goes out of business, bond holders get paid first. Whatever’s left goes to the remaining stock holders. This is the generally accepted reason why stocks are riskier than bonds. Furthermore, it’s also the reason why investors should require a bigger potential reward for investing in them. Over the long history of capital markets, stocks have collectively outperformed bonds.
Exposure to small-cap stocks: Investing in the market is reasonable for most investors if they are willing to accept the risk/reward tradeoff. Now, what specific types of companies exhibit higher levels of risk? Consider the following scenario: Two companies: Joe’s Coffee Shop and Starbucks both walk into a bank. Both would like to apply for the exact same loan. If I’m the bank owner, which company gets the lower interest rate on their loan? Starbucks of course! They have a longstanding business model with worldwide distribution and tremendous brand recognition. Joe’s Coffee Shop is a small, one-man operation that nobody’s ever heard of outside of a five mile radius. (For related reading, see: How to Find a New Financial Advisor Who's Right for You.)
Reward for Risk
It’s riskier to invest in the smaller company therefore; the bank should require a higher interest rate on the loan to Joe’s Coffee Shop. Investors have to be compensated for taking on the risk of investing in small companies versus big companies. Historically, the collective group of small company stocks has outperformed the collective group of large company stocks. They should. After all, they’re riskier.
Exposure to value stocks: Regardless of the actual size of the company, what about the perceived value of the company? On one end of the spectrum there are “growth companies,” loosely defined as firms whose earnings have grown faster than other’s and are expected to continue to do so. On the other end lies “value companies,” often represented as depressed or out-of-favor businesses whose price is low relative to the company’s actual net worth. Because these value companies have a depressed price, they exhibit higher levels of risk for most investors. This uncertainty requires compensation. As a whole, the collective group of what are deemed value companies has historically outperformed the group of growth companies. They should. After all, they’re riskier. (For more, see: Value or Growth Stocks: Which is Best?)
But diversification is still important! A diversified investment portfolio can eliminate the risk of any one particular company, country, sector or asset class from tanking an investor’s portfolio. There’s no such thing as a riskless stock or even a riskless investment. However, markets have historically rewarded different types of risk and therefore, risk helps to explain expected return.
How Returns and Information Are Linked
The search for expected return is the search for information itself. Unfortunately, not all leads are credible. The financial industry regularly rushes products to market citing new research without thoroughly understanding its validity. The research I’ve mentioned has been published for decades and has multiple Nobel Prize winners attached to it. (For more, see: The Importance of Diversification.)
Contrary to popular belief, there are very few “eureka” moments in the search for expected return. Today’s research more often than not stands on the shoulders of yesterday, building upon itself with incremental adjustments. For this reason, I generally recommend a healthy level of skepticism when the next big investment idea comes along. There’s a good chance it’s the same stuff we already know about just repackaged with attractive marketing.