Over several decades, financial academics have discovered a number of factors, often referred to as risk factors, that drive returns in the long term. These factors are evident in markets around the world and over long time periods:
The Market: There is a premium available from investing in a broadly diversified portfolio of shares, as opposed to putting all your money in the safest government bonds. This is called the market premium. Shares are more volatile than bonds, but with the offer of a higher expected return.
Size, Relative Price, Profitability: Within the equity market itself, there are three other premiums. Small companies have been shown to offer a higher expected return than large companies over time. Likewise, low relative price or ‘value’ stocks have delivered a long-term premium over high relative price or ‘growth’ stocks. Finally, more profitable companies have delivered a long-term premium over less profitable ones. Like the equity premium itself, these size, value and profitability premiums come and go. Then again, if they were there all the time, there would be no premium.
Term and Credit: Within the bond market, there are two premiums – term and credit. Term refers to how long the bond has till it matures or comes due. This can range from a few months to 30 years or more. Generally, the longer the term, the higher the expected return. The credit factor refers to the likelihood of the bond defaulting. Generally, there is a premium for investing in lower credit. However, these term and credit premiums (as with the equity, size, value and profitability premiums) are not constant over time.
In summary, financial economists have built a strong sense of what drives returns over the long term. Investors can build diverse portfolios around these long-term drivers, trading off risk and return according to their own tolerances, circumstances, goals and time horizons.
The academic evidence for what drives returns over the long term has been building over 70 years, a process than has accelerated since the 1960s and the development of computers.
The first breakthrough came in the early 1960s with the arrival of the Capital Asset Pricing Model, or CAP-M for short. The CAP-M was developed by, among others, William Sharpe, who later won the Nobel Prize in Economic Sciences.
Sharpe put forward the idea that investors are rewarded for ‘market risk’ — in other words, the risk that remains after all company-specific risk is diversified away. The more market risk you take, Sharpe said, the higher you can expect your investment returns to be.
Building on his work, two academics, Eugene Fama (another later Nobel laureate) and Kenneth French, later built a multi-factor model of stock returns. This was initially posed as a three-factor model (the market itself, size and relative price), but was later extended to a five-factor model (also incorporating profitability and investment).
While these factor premiums are evident in markets around the world, they are not there every year and are more volatile than the market as a whole.
More recently, other academics have claimed to discover literally hundreds of other premiums, to the point where this area has become known as a ‘factor zoo’. However, Fama, French and others have cautioned that some of these ‘factors’ are not sufficiently persistent or pervasive or practical to implement to be clear the bar of being reliable long-term drivers of return.
It’s an arcane and often impenetrable field for most people. For the average investor, though, it is enough to know that some of the most powerful minds in finance have identified basic building blocks around which you can assemble a diversified portfolio. How much you tilt your portfolio to these factors – the market itself, size, value and profitability in equities and term and credit in bonds – will depend on your own tastes, preferences and circumstances.
Have a read of my Investment Philosophy to discover more.
Courtesy of Robin Powell, The Evidence Based Investor.Back to Insights