It was a crisp Saturday morning, real estate agents planting their a-boards on street corners and hanging auction flags outside homes, while I enjoy a soy latte and a bowl of granola reading the weekend paper, whilst my 2 year old son is sharing his pancakes with a newly made friend, a large Golden Retriever. Who am I buying breakfast for!?
One of my favourite sections of the weekend paper is the finance/stock-tips section (after the property section of course). Why? It’s entertaining, it humors me, most importantly, I need to know what nonsense our clients could be reading.
“Sectors that will outperform the next quarter”
“Top 10 share predictions for 2016”
This daily market news and commentary can be challenging to our investment discipline. Some messages stir anxiety about the future while others tempt you to chase the latest investment fad, all in an attempt to generate a greater return.
Without getting involved in speculation and gut-feel decisions, how can investors target dimensions of higher expected returns and make confident investment decisions in order to enhance the return of their portfolios in a way that is sensible, in a way that is persistent across time and pervasive across markets? I’ve put together a few charts (using Returns 2), looking back as far as we can go, to help us find answers to these questions.
Let’s start off with the basics. It’s common knowledge that over the long-term, stocks outperform bonds, right? If you don’t believe me, here’s the evidence. An investment of $10,000 back in January 1980, would be worth $186,914 if you had invested in bonds, and $375,559 if you had invested in shares (to February 2016). That’s more than double your return! Of course, you took on the risk.
There it is, the first dimension of higher expected returns – the stock market over the bond market. Okay, okay, that was quite basic, but I did need to start somewhere to paint the picture that I’m looking at.
So let’s dig a little deeper. If the stock market is our investment universe, where should investors tilt their portfolios in order to gain exposure to dimensions of higher expected returns.
Decades of research has identified company size as a dimension, which also points to higher expected returns. As you can see from the chart we constructed below, not that we would endorse putting all your eggs in one basket – but if you had invested 100% of your portfolio in smaller Australian companies (as represented by the Dimensional Australian Small Index), your return would have been over 77% greater than the return of the ASX 200 Index.
To put this into perspective, let’s say you made a $10,000 investment in January 1980. The value of this investment would be as follows for each of the asset classes plotted and represented in the chart (to February 2016):
Bond Index: $186,914
S&P/ASX 200 Index: $375,559
Small Companies Index: $665,030
So we’ve now identified two dimensions that point to higher expected returns, stocks over bonds, and smaller companies over larger ones.
Want to know what absolutely dwarfs what we’ve seen above? Investing in companies that are under priced when compared to their relative value, such as price to earnings, price to book, and dividend yield. Click here if you want to know more about value stocks.
As you can see from the chart below, the index of ‘value’ stocks, over the long-run, has rewarded investors handsomely. Well and truly beyond the return of the S&P/ASX 200 Index, in fact, over 3.5 times.
Again, to put this into perspective, let’s say you invested $10,000 in January 1982 (dates are a little different to the earlier charts we constructed due to data history in finding a common base), here’s your return to February 2016:
Bond Index: $141,095
S&P/ASX 200 Index: $368,191
Small Companies Index: $472,836
Value Companies Index: $1,320,899
In this brief note, we have identified three dimensions of higher expected returns, that is, stocks over bonds, smaller companies over large, and value companies over growth. We have also identified that there is a way investors can structure their portfolios to target dimensions of higher expected returns without getting involved in speculation and gut-feel decisions. There is evidence to support these strategies, they are persistent over time and are pervasive across markets (if you want further evidence, feel free to ask, we’d be happy to share more data and evidence that’s not only Australian, but also global).
Investors do however, need to be patient, as these dimensions are not present each and every day, but over the long-run we can clearly see they pay off.
I would like to make one thing clear. It’s unlikely you would have invested 100% of your portfolio in any one of these asset classes. So I decided to put together a hypothetical portfolio as follows (which begins January 1982):
Bonds: 15%, Small Companies: 35%, Value Companies: 35%, S&P/ASX 200 Index: 15%
This diversified hypothetical portfolio would be valued at $593,335 at February 2016. A pretty decent return for a $10,000 investment, wouldn’t your agree?
The most interesting and surprising aspect of this exercise (for me), was the fact that the hypothetical portfolio’s largest loss was less than the largest loss of S&P/ASX 200 Index, even though the hypothetical portfolio’s return has been greater than that of the S&P/ASX 200 Index.
Unfortunately, we are not wired for disciplined investing. We follow our emotions and react to speculation and recent performance.
Next time you think about how much those school fees are going to cost, or the holidays you’d like to take, or the ideal retirement plan, whatever it is, just think about these three key steps:
- Plan, plan ahead.
- Make investment decisions based on evidence, not speculation.
- Get the help of a professional, unbiased, unconflicted adviser to challenge your thinking and keep you on track.
It’ll all be worth it in the end.