Updated: Jan 7, 2020
We believe that the goal of investment advice is to educate investors and increase their understanding of diversification, costs, and discipline. Understanding the time-tested data on stock returns is extremely important not only from an academic standpoint, but also from the standpoint of a successful investment experience.
Starting in the 1960's, economists began researching the behavior of stock prices. Decades of research and thousands of peer review academic studies of the drivers of stock market returns have led to amazing discoveries about the correlation of different stocks.
Academics have categorized the market by different factors (market capitalization, book value or sales over market price, and region, among others) to see how different types of stocks compare to one another around the world. From the studies, a consensus has developed identifying four factors or "premiums" that have been found within stocks and can be successfully implemented: Market, Size, Value, and Quality.
From the data we can see that, historically, stocks have outperformed bonds, small cap stocks have outperformed large cap stocks, value stocks have outperformed growth stocks, and stocks that have high profitability have outperformed stocks with low profitability. Furthermore, we have been able to design investment strategies around these different factors.
Most academics believe that the higher expected premiums associated with these factors are a return for taking on more risk. However, there are significant periods of time when investors are not rewarded for pursuing these areas in the market, hence, why they are considered "risk premiums." Therefore, it is important for investors to fully understand these risk premiums when deciding a particular asset allocation.
Historical Performance of These Factors
The data suggests that, historically, investors who have focused on these particular factors have been rewarded with higher returns. Figure 2 shows the historical size, relative-price, and profitability premiums for US, International/Developed, and Emerging Markets using the longest dataset available for each market.
From the figure we see that within the Emerging Markets Stocks, value stocks have outperformed growth stocks by approximately 3.66% per year from 1989-2018. The highest premium has been the Profitability premium in International Developed markets, delivering 5.60% per year from 1996-2018. The smallest premium has been the Size premium in the Emerging Markets, delivering 1.87% per year from 1989-2018.
While we should expect these premiums to be positive in any year, there are periods of time where they are not. Many are probably well aware that the Value stocks in the U.S. have not been favorable over the last 10-year period, ending 12/31/2018. Figure 3 below shows the annual performance for each premium in the U.S. from 1928-2018. A blue bar indicates a positive premium while a red bar indicates a negative premium.
As you can see, there are definitely more blue bars than red bars, but there are stretches of time where different premiums do not show up.
Although the average premium observed overtime has been positive, there is extreme variation around that average. For example, just looking at the value premium in the U.S., we can see that the simple historical average has been 4.70%. There have only been 11 out of 90 calendar years where the observed premium was within 2% of the historical average. See Figure 4 below.
The dashed line represents the arithmetic average (4.70%). The gray shaded area represents the 2.00% range around that average. The dark blue bars represent the annual observations that fall within the range (2.70% - 6.70%).
While the average value premium in the U.S. has been approximately 5%, it is more likely that an investor will experience a much higher or much lower premium in any given calendar year. The same conclusion holds for the other factor premiums.
The Long-term Appeal
While many investors are well aware of diversification- as a risk control- in terms of investments, it is also important to understand diversification in terms of time. Diversification is an important investment tool because we do not know which area of the market is going to outperform. Time diversification is following a robust investment style over a long period of time. We are more likely to capture factor premiums if we hold onto them for a long period of time.
If instead of looking at 1-year returns we now looked at 10-year rolling returns, how do the premiums in the U.S. look?
In Figure 5, each bar shows the 10-year period ending in that particular year. Once we move from 1 year to 10 years, there is an increased probability of seeing a positive premium return. This is the concept of time diversification.
From 1941-1997, there was not a single 10-year rolling period where value stocks underperformed growth stocks. It is important to note that the graph also shows that from 2011 through 2018 value stocks have experienced their worst performance since the Great Depression.
The Market Changes Quickly
We have already discussed the large volatility around a given premium’s historical averages. This highlights the importance of long-term discipline when pursuing these risk premiums within an investment portfolio. Figure 7 shows the historical 10-year annual rolling observations for the value premium sorted from lowest to highest.
You can see, for the 10-year period from 2009-2018, the value premium was the second lowest in history. But if we go back just eight years and look at the 10-year period from 2001 to 2010, the value premium switches to positive. This just emphasizes the importance of having a long-term focus when deciding to pursue these risk premiums within a portfolio.
We believe in the importance of good education and transparency when building an investment strategy for the long-term. Academic research has found certain factors or premiums within the market that explain the variation in its returns. Because there is significant volatility around these premiums in any given year, it is important to maintain a long-term focus.
Figure Source: Dimensional Fund Advisors LP.
Maimon Wealth Management Ltd. ("MWM") is a Registered Investment Advisor ("RIA") with the U.S. Securities and Exchange Commission (“SEC”). Advisory services are only offered to clients or prospective clients where MWM and its representatives are properly licensed or exempt from licensure.
The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.
The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.
Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results.
No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. All investments include a risk of loss that clients should be prepared to bear. Asset Allocation may be used in an effort to manage risk and enhance returns. It does not, however, guarantee a profit or protect against loss. Diversification does not ensure a profit or guarantee against loss.