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Logical Investing

May 07, 2020
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Over the last 2 months I've spent a lot of time contextualizing the crash we've all endured, how markets tend to behave in situations like this, and why we should be confident going forward....I have addressed why we shouldn't panic and make adjustments, but that's not very specific. Going forward, I'm sure you're curious about how exactly we should proceed. 

How should we invest? 

This will address what I think is the best way going forward --it's not investment advice for you, just a path which I think makes some sense. 

But before I get into it, I'll add that this is not specific investment advice. If you're a client of my firm then you're already getting this advice represented in your portfolio in one way or another. If you're reading this and you're not a client, then know that the only time I actually give advice is when I know you and your situation very well. In other words, a doctor may really think a certain prescription drug is great for treating a condition, but they won't prescribe it to people until they know they have that condition. If you're not a client, then I don't know your condition, so this isn't me making a diagnosis --instead, it's an evaluation of financial science. 

Just a heads up: this email deploys a bit more financial jargon than I normally try to use. I've provided some links as additional resources to help understand some of the terminology. Or if anything is unclear or confusing, feel free to ask for clarification. 

If you've read my previous emails, then you know that diversification is important, market timing isn't a sound strategy, and trying to outsmart other investors is an extremely difficult thing to do.

In fact, from 1994 through the end of 2018, the annualized rate of return for ALL stocks in the U.S. was 7.2%. If you exclude the top 10% of best performing stocks, the annualized rate of return is just 2.9%. If you exclude the top 25% of stocks, the annualized return is a negative 5.1%!... It's tempting to want to only pick the best stocks, but the cost of getting it wrong can be significant, so diversification is important. 

Now that we know diversification is important, what are some things we can do to be diversified while trying to tilt the odds in our favor? 

The following are specific principles, in a logical progression, which can help people understand how to invest. 

Let's start by reviewing and dissecting the below chart: 

Over the past 50 years, academic research has identified variables that appear to explain differences in average returns among stocks. 

 

The chart above highlights these certain variables which have stood up to rigorous testing and evaluation. I believe in emphasizing these variables.

 

You'll see me refer to these variables as "premiums" going forward. 

PREMIUM #1: Which market are we investing in? 

In the 1960s, William Sharpe and others conducted asset pricing research that led to development of the Capital Asset Pricing Model (CAPM), which proposed "the market" as a driver of expected returns. Known also as the single-factor model, CAPM reinforced the value of diversification and provided a simple, rational approach to measuring investment risk and expected returns relative to the market.

SIMPLE TRANSLATION OF THE ABOVE PARAGRAPH: The market you're investing in is a primary determinant of rate of return. Most stocks behave similarly, most bonds behave similarly, most real estate behaves similarly, etc. 

Additional Resources: What is the CAPM? (Investopedia)

In the chart above, “Market minus T Bills” shows the outperformance of stocks over T Bills over 10 year periods. The blue bars represent periods where stocks outperformed, while the red bars represent periods where T Bills outperformed. 

Moving forward, there simply has to be inflation at some point with the amount of dollars entered into the economy over the last 12 years (and specifically, the last 12 weeks)  by the federal reserve. 

Inflation can present a significant risk to investors holding too much cash or bonds. 

Traditional hedges against inflation are gold, real estate, and stocks. I’m not a fan of gold because I like investments that pay us while we hold them (like how stocks pay dividends, real estate pays rent, and bonds pay interest). 

I’m a believer that stocks and real estate are the key to beating inflation, and history is on our side of that argument. When we buy stocks, we’re buying the companies that are charging us more for the stuff we want to buy due to inflation. With real estate, there’s a fixed amount of the commodity and more dollars chasing that fixed amount. I believe those supply and demand relationships are compelling. 



PREMIUM #2: How big are the companies we want to own? 

THE SIZE EFFECT

Advancing research during the 1970s identified additional factors in stock performance. In 1981, Rolf Banz observed that small company stocks tended to have higher returns than large company stocks, as measured by their market capitalization. The size effect provided a more detailed framework for understanding the dimensions of equity performance.

SIMPLE TRANSLATION: It's easier to grow something smaller than it is to grow something bigger. My firm's growth rate is likely crushing most Wall Street firms because I'm small (but look out, Wall Street). 

Additional Resources: Small vs. Large Cap Investing (Investopedia) 

In the chart above, “Small Cap minus Large Cap” shows the outperformance of smaller companies over larger ones over 10 year periods. The blue bars represent periods where small companies outperformed, while the red bars represent periods where large companies outperformed.

PREMIUM #3: What are the fundamental characteristics of the companies we want to own? 

THE VALUE EFFECT

In a highly influential paper published in 1992, Eugene Fama and Kenneth French synthesized much of the previous research on asset pricing and found that stocks with low relative prices (or high book-to-market ratios) offered higher average returns than companies with high relative prices (low book-to-market ratios). They concluded that company size (small vs. large) and relative price (value vs. growth) were strong determinants of stock performance, and when combined with the market, explained most of the average differences among stock returns.

SIMPLE TRANSLATION: Companies with stronger balance sheets have a buffer when times get tough. They also tend to pay out higher dividends. Value investing has been popularized by notable investors like Warren Buffett. 

Additional Resource: Growth vs. Value Investing (Fidelity)

“Value minus Growth” shows the outperformance of value stocks (stocks trading at a lower price relative to their earnings) over growth stocks over 10 year periods. The blue bars represent periods where value companies outperformed, while the red bars represent periods where growth companies outperformed.

Take note of the last decade of red bars… This is a massively important observation which I'll address in a minute. 



PREMIUM #4: How profitable are the companies we want to own? 

THE PROFITABILITY EFFECT

More recently, Fama, French, and other academics have identified profitability as a dimension of expected returns. When controlling for size and relative price, research shows that more profitable firms have higher expected returns than less profitable firms. 

SIMPLE TRANSLATION: Some really smart economists kept researching, kept scrubbing data, and ultimately found that the profitability of a company is important. Makes sense, right? 

Additional Resources: Emphasizing Profitability in Stock Portfolios

“High Prof minus Low Prof” shows the outperformance of companies with higher profitability over companies with lower profitability. the blue bars represent periods where higher profitability companies outperformed, while the redbars represent periods where lower profitability companies outperformed.

Here's the performance of those factors over time. 

Again, the blue bars shows the excess return of each factor. 

So those are the four factors... Now what? 

All that history is great, but here's the thing:

Nothing always works, which is why we can’t dive completely into small companies or value stocks or high profitability companies. 

We just have to highlight these factors to not get left behind during periods where they don’t outperform. 

Remember how terrible value stocks looked over the last decade in the graph above?

 

Here's more on that: 

The chart above shows something truly astonishing: 

Since 1926, value stocks have produced an annualized rate of return of 12.7%. 

Over the last decade, Value stocks have produced a 12.9% annualized rate of return…. Pretty close to the long run average. 

Conversely, since 1926, Growth stocks have produced an annualized 9.7% rate of return, and over the last decade they’ve produced a 16.3% rate of return. 

In short, Growth stocks are outperforming their long run historical average by nearly 7%!

In fact, we haven’t seen this kind of divergence between Growth and Value since right before the Tech Bubble burst (2000). 

Speaking of the 2000 Tech Bubble, here’s how various stock markets performed during the 2000-2009 decade. 

 

Not only does the above chart serve as a great reminder that US Large Companies (i.e. the S&P 500) don’t always perform the best, but that international markets are worth considering. 

Part of the reason we may think US companies always perform best is because they have...at least for the last 10 years.

Here's the last decade: 

People have a tendency to want to buy more of what’s done well recently and less of what hasn’t done well. The last 10 years has seen US large companies (the S&P 500 Index) beat almost every other asset class.

We have to avoid the urge to believe this will go on forever. 

What about the entire 20 year period? Here you go: 

Global diversification wins over the last 20 years. So does an emphasis on small companies and value stocks. 

So here's the trillion dollar question: 

(trillion is the new billion, apparently)

What will the next 20 years look like? 

My Answer: 

"I don't know."

But in a situation where inflation is likely, where the U.S. has seen a decade of outperformance, and where companies with stronger balance sheets have underperformed for a decade... I like the idea of emphasizing a global stock focus and highlighting some of these factors that have proven resilient over the long run.

... With ALL of the above said, the "best" approach is the one that you can stick with, which also puts you in the best place to accomplish what's important to you. Let me know what's important to you and we'll figure out a way to get you more of it. At the bottom of this email is a picture of what's most important to me right now. 

This email itself isn't "investment advice", it's just radical pragmatism.

If you want investment advice, reply to this email or book a call or zoom meeting here: https://calendly.com/hardingwealth/covid19

Be well, 

Adam Harding, CFP

480-205-1743

Disclosures: 

Data & Charts provided by Dimensional Fund Advisors LP.

Past performance is no guarantee of future results. Actual returns may be lower.

In USD. Indices are not available for direct investment. Index returns are not representative of actual portfolios and do not reflect costs and fees associated with an actual investment. MSCI indices are gross div. Yearly premiums are calculated as the difference in one-year returns between the two indices described. Market minus Bills: Fama/French Emerging Markets Index minus the One-Month US Treasury Bill, which is the IA SBBI US 30 Day TBill TR USD, provided by Morningstar. Small Cap minus Large Cap: Dimensional Emerging Markets Small Cap Index minus MSCI Emerging Markets Index. Value minus Growth: Fama/French Emerging Markets Value Index minus Fama/French Emerging Markets Growth Index. High Prof minus Low Prof: Fama/French Emerging Markets High Profitability Index minus the Fama/French Emerging Markets Low Profitability Index. MSCI data © MSCI 2020, all rights reserved. See “Index Descriptions” in the appendix for descriptions of Dimensional and Fama/French index data.