Part 4: Conclusion

All of the information used to identify where returns come from is historical data. The data shows us how asset classes behave relative to each other (correlation), how much risk (volatility) is associated with each, and how much return we can expect over long periods of time.

But, it’s important to distinguish between what history can and cannot show us. While historical data does show us how the market works and how we can be ideally diversified to capture returns, it does not tell us which specific stocks or asset classes will be up or down from year to year or anytime in the future. It’s popular practice to analyze data and trends in an attempt to predict what the market will do next, many investors even expect that type of prognostication from their advisor. The problem is that humans simply can’t predict the future. As much as we like to think we can beat the market, the best we can hope for is to guess correctly, which is much more like gambling than investing.

Based on what we know about the market, we can capture amazing market returns with some discipline and patience. We know the market is efficient so it’s useless to try to predict or beat it (part 1), we know we can reduce risk and increase returns with strategic diversification (part 2), and we know that certain asset classes outperform others over time (part 3).

By understanding and putting these principles to work as an investor, you can stop stressing, stop guessing, and let the market grow your money.

Instead of making a guess as to what the market will do next year, put yourself in the best possible position to capture the returns it will offer, whichever sector they come from.

Part 3: The Three-Factor Model

The Three-Factor Model was introduced by Eugene Fama and Ken French in 1991. You might remember Fama from Part 1, he is also responsible for the Efficient Market Hypothesis back in the 1960s. The Three-Factor Model is a sort of subset theory to Modern Portfolio Theory, it takes things a step further. In Modern Portfolio Theory (Part 2) we see that strategic diversification is important for successful investing, The Three-Factor Model deals with the ‘strategic’ part of diversification. This research is very important for constructing portfolios. It means that you don’t want to simply owns lots of different asset classes, you want to own the right amount of the right asset classes to increase returns at minimal risk (volatility). As you might have guessed, there are three factors:

  1. Stocks outperform bonds (market effect). We want to be in the stock market. Bonds are good as you get closer to retiring because they’re not as volatile, but stocks will give the long-term returns that will allow for you to retire in the first place.
  2. Small companies outperform large companies (size effect). Large companies are the popular investment. We hear about the S&P 500, Dow Jones, and Nasdaq in the news almost exclusively; they’re all measurements of the largest US companies. Large companies are cheap to own, easy to trade, and you’ve heard of many of them, they make for a very popular investment. But over time, small companies will give you better returns. An ideal portfolio will not only include small companies, but it will also lean towards them.
  3. Value companies outperform growth companies (value effect). ‘Value’ means that the stock of a company is valued more closely to the actual worth of its assets. The stocks don’t have a built-in premium for growth potential because the companies aren’t expected to grow much. The stock prices of growth companies are much higher than the actual value of the company’s assets because of their potential, their expected growth. They’re also more popular than value companies, examples include Apple and Amazon and Google. Over time, value companies will give a better return than growth companies. Again, an ideal portfolio will not only include value companies, but it will also lean towards them.

The point of all this research is to help construct a better portfolio. Investing is not a shot in the dark or a gut feeling. It’s not even an educated guess about which asset classes or companies will make a jump next year. Investing is an academic exercise. We put these pieces of research together to model a portfolio that will put investors in the best position to capture market returns next year, and the year after, and every year moving forward. There are no pretensions that we know what will happen next year, we simply stay disciplined and diversified, we follow the rules, and we let the market do its work.

Part 2: Modern Portfolio Theory

Modern Portfolio Theory is another very important bit of research. A man named Harry Markowitz began working on this theory back in the 1950s. His goal was to figure out how to optimize the relationship between risk and reward in investing. That sounds complicated just reading it back to myself, but it does make sense, in fact, Markowitz received the Nobel Prize in 1990 for his work. A couple of quick definitions before we jump in: 1) risk in investing means volatility, how much a stock, or class of stocks, can move up or down in a year, usually referred to as standard deviation; 2) reward is a little more obvious, it’s the expected/historical rate of return for a class of stocks; 3) a class of stocks is called an ‘asset class’ (an example of an asset class would be large growth companies, or small companies, or small international companies, basically a sector of the market).

Risk and reward are two easily measurable characteristics of a stock or an asset class. Different asset classes obviously behave differently, they each have unique expected risks and rewards; the important thing to remember is that they also respond to market conditions differently, they don’t all move the same way at the same time, you can say they ‘correlate’ to each other differently. Harry Markowitz wanted to figure out how the risk and reward expectation of these different asset classes could be helpful to investors. His studies led him to the idea of an ‘efficient frontier.’

Since we can measure risk and reward year by year going backward, we can compare how the different asset classes have moved relative to each other, we can see how they’re correlated. Using a lot of math (Markowitz created an algorithm before algorithms were cool), Markowitz determined that owning different asset classes could reduce the overall risk of your portfolio while maintaining a great return. Since asset classes don’t always move the same way, one could go up while the other stays flat, or one could be going down while the other goes up. Say there’s a market downturn and you own a bunch of different asset classes, not all of them are going to decrease by 50%, some will remain flat, some will go down 20%, some might even go up a little bit. Overall, your portfolio will lose a fraction of what it might have lost if you were invested in one asset class, or worse, in one stock. By spreading the risk around through the different asset classes, you can actually achieve a better return with less risk. You’ll never be able to erase all risk in your portfolio, some years the account will go down, but you can dramatically reduce large swings using diversification.

So diversification is your friend. But Markowitz didn’t just determine that diversification is helpful, he also determined that there’s a mathematically ideal way to organize your investments to achieve the maximum amount of return for a given level of risk. Here’s a helpful picture to show how the Efficient Frontier works:

Every portfolio has a risk level based on how the portfolio is diversified. The question is, how does the diversification of your portfolio stack up against the Efficient Frontier? Unfortunately, the vast majority of portfolios haven’t accounted for the Efficient Frontier. Investors are routinely exposed to more risk than their returns warrant. An actively managed account isn’t even in the ballpark, the risk associated with those accounts are off the charts. But even a portfolio filled with passive index funds typically falls short, they routinely shade towards the Large Growth companies asset class because it’s cheaper to own, but it offers less return for the risk it demands. The key is to be broadly diversified with an ideal amount distributed between each different asset class. It’s an efficiency game, there are more returns and less risk to be had when the portfolio is organized and diversified the right way. We can actually look at any portfolio and see where it lands on the efficient frontier based on the stocks and asset classes it holds.

Here’s the basic point, and what you can take away from all this: diversification is the investor’s friend, and optimized diversification is the investor’s best friend. Make sure you know how your portfolio measures up to the Efficient Frontier.

Part 1: Efficient Market Hypothesis

The Efficient Market Hypothesis is a very important bit of research. It began when a man named Eugene Fama wrote his doctoral thesis in 1965 stating that markets are efficient. Here’s what ‘Efficient Market’ basically means: the current price of a stock is the right price (it’s not underpriced or overpriced) because all of the available information (news) has already been accounted for in that price. Let’s break down what that means for us:

  1. It means that past prices and movements of stocks have no correlation to future prices and movements of stocks. If the price is always what it should be, there’s no way to predict how the stock prices will move in the future (even based on trends and charts) because we don’t know what the new information (news) will be in the future. Even if you went deep and did a study on a few companies, you still wouldn’t have anything better than a guess for how the stocks of those companies would perform because those stock prices already reflect the information you studied, and you don’t know what new news or information will come out tomorrow to affect the price. Basically, the Efficient Market Hypothesis means people can’t predict the stock market because people can’t predict the future. That’s not to say that no one ever predicts the market correctly, but that when they do it’s a facet of chance, not the ability to tell the future, and it has never been done consistently over time.
  2. It also means that there’s no benefit in trying to capture better returns than the market offers (which, over long periods of time, are really great). If the market is efficient, instead of trying to outperform it by actively buying and selling, guessing which market sectors are poised for growth, or indulging in any other prognosticating efforts, we should focus on capturing the returns that the market offers as efficiently as possible (that ‘efficient’ word just keeps popping up!). We do this by strategic diversification (owning a large number of different stocks) and regular rebalancing (making sure you keep owning the same percentage of the different types of stocks). Free markets grow, they offer amazing passive return over time. We simply capture the returns by owning the market.

We mostly hear prognostications on the news. The default mindset in the media, and for most of us, is that we need to find the right stocks, the right market sectors, buy in at the right time, get out at the right time, and that’s how you make money in the stock market. But, since none of us can consistently predict the future, our default investment strategy essentially amounts to gambling. Great returns don’t typically come from gambling. In fact, all of the data suggests that the gambling approach vastly underperforms compared to the market over time.

The Efficient Market Hypothesis shows us that returns don’t come from an active investment (gambling) strategy. They don’t come from predictions, prognosticating, timing the market, or any type of guessing the future. Returns come from free markets rising over time. So we can stop stressing! No more guessing, no more betting, no more timing, we can own the market and let the market do its work.

In Part 2, we cover how to best own the market.