Expected Sources of Premium Stock Returns Part III: Capturing Return Premiums Requires Resolve

In our last post, we described how small-company and value stocks have served as a source for premium returns in the past. Today, we’ll explain how capturing these returns has rarely been as easy or obvious as 20/20 hindsight might lead us to believe.

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Figure 2

Consider Figure 2, from 1928–2014. It illustrates three critical points about how the average premium returns we described in our last post were actually delivered.

(1) Average does NOT mean always. The red bars above show how these factors that have outperformed overall have temporarily underperformed. For example, it’s no surprise that, even though the market has significantly outperformed risk-free investments over time, it significantly underperformed in 2008, in the midst of the Great Recession.

The take-home: This is what the “risk” part of a risk premium is all about: To reap any reward, you have to withstand the risk when (not if) it appears.

(2) Extremes are the norm, not the exception. Taking a closer look at Figure 2, the horizontal dotted lines illustrate the average returns cited above. Note how often actual annual returns shot significantly above or below their long-term average.

The take-home: Near-term market volatility is not only expected, it is the norm.

(3) If you zig, the market may well zag. Now consider the bars in the yellow box above. Note how the market as a whole (the top row) did fairly well around 1998, while small-cap and value premiums (the next two rows) did not. Our sources for expected returns can, and often do, move up and down independently from one another.

The take-home: The current market climate in which small-cap and value stocks have lagged behind general market returns has happened before; it will likely happen again.

In our next and final post in this series, we’ll tie all these concepts into a compelling conclusion: What’s an investor to do (or not do)?

About Chas Boinske

Charles P. Boinske, CFA, is a 30 year investment management veteran overseeing the strategic direction and portfolio management process for Independence Advisors, LLC. Have a question for Charles? CLICK HERE TO ASK CHARLES

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