Expected Sources of Premium Stock Returns Part IV: Risk Premiums, Lucky Monkeys and Patient Practice

In our series of posts so far, we’ve described how and why we have identified small-company and value stocks as likely ongoing sources for risk premiums. This begs one more question: Why not just get out of various return factors when they’re underperforming and get back in when things are looking up?

The Market-Timing Myth

That would be a great idea, if only factors didn’t under- and outperform so frequently, and with such little notice. If you don’t remain on hand to capture their expected premium returns when they happen – which is often when you least expect it – there’s little advantage to being invested in them to begin with; they may even cause more harm than good.

Financial analyst Dougal Williams explores the problems with market timing in his CFA Institute article, “O Value, Where Art Thou?” He focuses on value stocks, but the concept applies market-wide:

“Markets can shift in an instant and the value premium can return with force. … Consider, for example, the decade that ended in October 2000. Growth stocks in the United States had outperformed value stocks by 2.1% per year over the preceding 10 years. Yet just seven months later, a look in the rearview mirror provided a completely different picture of trailing 10-year performance: Value stocks had outperformed growth stocks by 2.4% annually.”

With this and other robust historical evidence as our guide, it appears that the climate we are experiencing today is more likely history repeating itself versus a brand new market condition. In fact, we believe it’s this very state of risky uncertainty that has generated premium returns in the past – at least for those who have stayed invested through thick and thin.

What’s an Investor To Do (or Not Do)?

The evidence continues to indicate that expected small-cap and value premiums remain alive and well. That said, using hindsight as our guide, we can’t guarantee it, nor do we know how much risk we’ll have to endure along the way. That’s why we also recommend maintaining a well-diversified portfolio that reflects your goals and risk tolerances. While investing in more market risk still likely equates to earning higher market returns over the long-run, diversifying the risk remains your most dependable safety net for the times when it does not.

William Bernstein, MD, PhD, is one of our favorite financial authors. In an International Business Times interview, Bernstein had this to say about return premiums:

“There is no ‘returns fairy.’ … They may seem to exist – you may see people who appear to have done very well. They’re lucky monkeys, but the people who have done the best returns over the last 10 years are not likely to be the ones to make the best returns in the next 10 years.”

This is a powerful statement to remember as we reflect on a challenging period for investors who have tilted their portfolios toward small-company and value stocks. It helps us understand why patient, evidence-based strategy using personalized, globally diversified portfolios remains your best course in a market that is well-known for its frequent displays of monkey-business.

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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