An accumulation of studies since the 1950’s has identified three risk factors that form the backbone of an evidence-based portfolio.
- The Equity Premium – The additional return investors should expect to earn for taking the risk of investing in stocks rather than short-term bonds. (6.27% per year since July, 1926)*
- The Small Cap Premium – The additional return investors can expect to earn for taking the risk of investing in small stocks versus large stocks. (2.11% per year since July, 1926)*
- The Value Premium – The additional return investors can expect to earn for taking the risk of investing value stocks (companies with lower ratios between their company stock price and various accounting measures such as earnings or book value per share) and growth stocks. (4.00% per year since July, 1926)*
It’s important to note that these return premiums are variable. Stocks don’t always outperform bonds, value stocks don’t always outperform growth stocks and small stocks don’t always outperform large stocks. The keys to harvesting these premiums are discipline and the patience that comes from confidence in the knowledge of the sound economic reasons that underpin the investment strategy.
These three factors were made famous by the paper, The Cross Section of Expected Stock Returns which was published in the Journal of finance in June of 1992. Author, William Bernstein wrote an excellent summary of the impact of this important paper on the tenth anniversary of its publishing in 2002.
For a broad, very readable, history of the development of the ideas about how the capital markets function, I highly recommend Capital Ideas: The Improbable Origins of Modern Wall Street.
The portfolio weightings of the three factors above are chiefly responsible for the returns of the vast majority of portfolios. Subsequent research has offered evidence that market timing, stock picking, and day trading are detractors from returns.
We have created a video to explain this important topic. It is titled Evidence-Based Investing Insights: Part 3 Return Factors. I hope that you find it helpful. Feel free to email me with questions.
*Source: Returns Program. 7/26 – 12/14