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Today’s look at your wealth journey investment insights is going to require quite a bit of focus to make it through to the end. We think you’ll find the information valuable for your own personal investment strategy.
Your financial journey can be fraught with uneven terrain and unexpected hurdles. Using an evidence-based strategy, though, can keep you on course.
Assessing the Evidence (So Far)
Studies dating back to the 1950s identify three stock market factors that form the backbone for evidence-based Investing:
- The equity premium – Stocks (equities) have returned more than bonds (fixed income).
- The small-cap premium – Small-company stocks have returned more than large-company stocks.
- The value premium – Value companies have returned more than growth companies. Value stocks are companies that appear to be either undervalued or fairly valued by the market, compared with their growth stock counterparts.
Similarly, academic inquiry has identified two primary factors driving fixed income (bond) returns:
- Term premium – Bonds with distant maturities or due dates have returned more than bonds that come due more quickly.
- Credit premium – Bonds with lower credit ratings (such as “junk” bonds) have returned more than bonds with higher credit ratings.
[Source: Fama, Eugene F. and Kenneth R. French. 1993. “Common Risk Factors in the Returns on Stocks and Bonds.” Journal of Financial Economics, 33(1), 3–56.]
The What and the Why
It’s simply not enough to just know that these factors exist. We need to know why the factors exist Imagine a doctor telling you that you have an infection, then sending you on your way with no reason why it may have happened or treatment plan.
Explanations for why persistent factors linger often fall into two broad categories: risk-related and behavioral.
A Tale of Risks and Expected Rewards
It appears that persistent premium returns are often explained by accepting market risk in exchange for expected reward. It’s contained, quite neatly, in an old adage: Nothing ventured, nothing gained.
For example, it’s presumed that value stocks are riskier than growth stocks. In “Do Value Stocks Outperform Growth Stocks?” CBS MoneyWatch columnist Larry Swedroe explains: “Value companies are typically more leveraged (have higher debt-to-equity ratios); have higher operating leverage (making them more susceptible to recessions); have higher volatility of dividends; and have more ‘irreversible’ capital (more difficulty cutting expenses during recessions).”
You’re putting something on the line by investing in a value company, but you also stand to gain more.
On Guts
There may also be behavioral shortcomings at play. That is, our basic-survival instincts often play against otherwise well-reasoned financial decisions. Preservation and protection can override assuming appropriate risk.
The market may favor those who are better at overcoming their impulsive gut reactions to breaking news.
This, too, is neatly summed by an old adage: Fortune favors the bold.
The “human factor” contributes significantly to your ultimate success or failure as an evidence-based investor. The fascinating field of behavioral finance will be the focus of future blog posts.
Your Take-Home
Factors that figure into market returns may be a result of taking on added risk, avoiding the self-inflicted wounds of behavioral temptations, or a mix of both.
Ultimately, your roadmap needs reasons behind each decision point. You can’t take rights and lefts at random because it feels right. Understanding stock market factors will help you on your journey and give you a clear picture of how to reach your destination.
If you’ve made it all the way to end of this post and enjoyed the journey, you’ll no doubt look forward our next post where we talk about new factors for evidence based portfolios
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