Investing has evolved over the last fifty years. In the past, if you wanted to invest in the stock market you headed down to your local Merrill Lynch office and bought individual stocks through a broker. Fifty years ago there was a common belief that you could hold 10-20 high quality (blue chip) stocks, along with some bonds and have an adequately diversified portfolio.
Fortunately, for investors the field of academic finance began to attract many fine minds. People such as Professors Markowitz, Sharpe, Merton, and Fama began to research stock market returns, efficient portfolio construction, and bond market returns. This research has advanced the discipline of finance and investing, taking us from the dark ages of stock selection to the new age of modern portfolio theory.
These pioneers, among others, determined that a few basic principles maximize an investor’s chances of reaching his or her financial goals.
The price of a publicly traded stock or bond reflects all of the information (news) at the moment of the trade. Markets are too competitive for “mis-pricing” and prices change in response to new information. Academic research has shown that it is extremely unlikely that anyone can consistently predict the news in advance. Wise investors avoid CNBC, the Wall Street Journal, and the internet when making investing decisions.
Higher risk equals higher expected return. Since one can’t consistently find mis-priced assets, the only way to increase expected (potential, not guaranteed) return is to take more risk. Stocks are generally riskier than investment grade bonds so one should expect a lower long term return from a portfolio primarily invested in bonds versus a portfolio primarily invested in stocks.
Diversification is one of the few “free lunches” in investing. Each security has its own unique risk which you can diversify away with a portfolio of many securities. Since the unique security risk can be diversified away, investors are NOT rewarded for holding a portfolio of individual stocks (say 20 or 30). Index funds, holding a broad cross-section of the market allow any investor to gain adequate diversification at low cost.
These principles still guide wise investors. Research by Eugene Fama and Ken French in the early 1990s advanced our understanding of stock returns beyond the total stock market approach to diversification. They analyzed which factors explained the difference in stock returns. Their research concluded that three factors explained the majority of expected stock returns over the long term. Note that expected returns are not GUARANTEED returns.
The factors are:
Stocks themselves provided a higher expected return than bonds
Small stocks provided a higher expected return than large stocks
Value stocks (stocks where the price of the stock is relatively low) provided a higher expected return than growth stocks.
Why is this important to investors? Each of the three factors was not highly correlated with the others meaning that, over the long term, an investor can create a portfolio that has a higher expected return for a given level of risk. As opposed to a portfolio focused on one factor—investing in stocks in the first place.
How can investors benefit from constructing a portfolio that incorporates the three factors? Next week, we will look at an example of investing in the stock market versus investing in stocks using the three-factor model.