This approach is for your Retirement must-have-money, when you are not investing for hopeful quick short term gains through constant buying and selling. For your future retirement money consistency in growth is all-important. Speculating is NOT what you want for this money!
Every investor knows that if they could see into the future with a crystal ball, investing would be a breeze and returns would soar into the stratosphere. Common sense aside, historical facts alone reveal that no one knows the future, and navigating the rough seas of equity markets does not create confidence as markets rise and fall like the waves of the ocean.
But what if there was a method of building portfolios that had the powerful advantage of 20/20 hindsight that we could employ to become successful investors? There is such a method that can give investors this edge. It involves 2 important components.
- Apply Positive Return Positioning – a simple but very effective method that promotes the opportunity to sell high and buy low and have your money there when you need it, on time and in a safe, secure place ready to use. Please read my white paper for all the details: Positive Return Positioning. But for this strategy to work at its best, it must be coupled with an Economy-Driven Multifactor Portfolio approach – the second component.
- Build an Economy-Driven Multifactor Portfolio – quite simply it is essential that it’s designed from the beginning to operate well in any economy, good or bad, so you must build it foundationally to do just that. Most importantly, in a down economy it must survive well by implementing non-emotional, time-tested methodologies. Its structure demands that it owns many market sectors that incorporate very broad, diversified holdings, thereby greatly minimizing risk. These market sectors in the aggregate by default hold hundreds of securities. This structural make-up enables the portfolio to quickly rebound when market cycles return positive.
This Economy-Driven Multifactor design captures market returns through its insightful concept of owning the market sectors that drive national economies. Since markets and asset classes do not normally move in tandem with each other, a well-crafted portfolio also holds those securities that tend to react in opposition to each other during differing economic conditions. This reduces volatility, which brings stability and improved performance, because this design does not have to guess which market sector will outperform another in any given month or year. Because this structured approach is pre-designed to work through strong and weak economies, each year an investor can look backwards (20/20 hindsight) and see that they owned the right stuff in up and down markets, and it performed well, without the proverbial crystal ball.
Let’s take a closer look at the underlying philosophies that combine to create a powerful advantage offered by an
Economy-Driven Multifactor Portfolio
Academic-Scientific Investing
Harry Markowitz introduced the modern investment age with his landmark work on building optimal portfolios through diversification and mean-variance analysis. He explained his theory in a Journal of Finance article titled “Portfolio Selection,” published in 1952. His theory emphasized making investment decisions based on risk, evaluating investment performance at the portfolio level, eliminating specific stock risk through diversification, and holding assets that are not highly correlated (assets that move opposite of each other during volatile conditions in the marketplace). Markowitz constructed a theoretical “efficient frontier” where a set of optimal portfolios offered the best level of return for given amounts of risk or the lowest level of risk for expected return. His model set the stage for a new investment approach that was based on a quantitative, risk-aware process. In 1990, he shared the Nobel Prize in Economics with Merton Miller and William Sharpe for their contributions to modern finance.
This seminal work influenced many to further pursue investigative research in the area of scientific investing methodologies. Along with the “efficient frontier” work of Dr. Markowitz, noted economists Eugene Fama and Kenneth French formulated a foundational investing measurement tool, the Three Factor Model(more on this later). These new models of investing methods helped to usher in the fee-only investment advisory approach.
Eventually, it would change the model for investment advice. By no longer selling product for commissions, advisors could now focus on designing total plans and educating clients, often with a multifactor investment philosophy. With these tandem developments of scientific investment theory, evaluative investing kicked into overdrive, continually deepening our understanding of how markets work and helping us solve risk problems. No longer would investors need to speculate and guess about the future directions of securities. Now they could implement investing science when building portfolios that provide the opportunity to harvest real market returns without constantly buying and selling, market timing and speculating. This simple model offers investors a plain sense of purpose and function with their investing that works in a common-sense, logical, and understandable manner.
Capital markets compensate investors for taking risks, but you should only take intelligent risks based on facts, not forecasts or the emotions of Wall Street brokers and advisors.
You work for many years earning a living. You convert the energy of your physical and intellectual capital into transferable energy—money. You then carefully invest your money in the marketplace hoping for a good return. Your investment powers a company’s productivity (people at work) that in turn creates growth of capital, in which everyone should profit. Your investment then returns to you in an increased amount. This is REAL investing-putting money to work in markets that produce goods and services that entire populations of people need and want. This greatly reduces risk and outperforms the majority of active trading professional investors as shown in independent studies from Dalbar, Standard and Poor’s, Morningstar, etc.
The opposite of real investing is referred to as speculation. Speculators often “invest” in precious metals, baseball cards, art, jewels, hot stocks, etc., hoping that someone will come along and purchase them back at a greatly increased price. Speculators also invest with the prevailing winds-what’s hot today, what market sector might outperform this month or next-thus allowing the emotions of fear and greed to guide them. “Real investing” invests in the efforts of people, in their hopes and dreams and hard work. Unfortunately, many professionals engage in speculation, usually with OPM- “Other People’s Money”.
Speculating by advisors also involves the practice of actively trading a client’s securities through market timing and stock picking (or mutual fund picking) while at the same time touting past returns that have ZERO guarantee of being duplicated, because their investing model changes from month to month as they buy and sell with the changing tides and emotions of the markets. They do all this in hopes of beating the markets (referred to as alpha in the industry), but unfortunately for clients that rarely happens, and the increased costs of trying to do so further hurt client returns. This form of speculation, usually with OPM, has cost investors untold billions over the last two decades.
According to the most recent data from Standard and Poor’s, passive asset allocation has outperformed 70-85% of actively managed funds over the long term. (Standard and Poor’s indices vs. active funds scorecard April 25, 2009) After accounting for the unwanted taxable distributions, excessive fees, unnecessary turnover, and other variables such as high-frequency trading, returns are unnecessarily reduced. Active management strategies like stock picking and market timing are often no better than a trip to Vegas, usually finding the time spent rarely paying off.
The goal of investors should be to secure a capital-market rate of return on a consistent basis. A broad-market, asset-allocation, economy-driven design can reduce unnecessary drag on performance, thereby helping investors to receive consistent returns.
Trying to beat the market (i.e. positive alpha) by scooping on the supposed inefficiencies of markets is no better than trying to look-into a crystal ball and attempting to predict the future. Predictions are a dime a dozen, and investors often miss the strong returns that markets provide by holding the wrong securities at the wrong time.
Market forecasters are often accused, and rightfully so, of doubletalk-couching their predictions in such convoluted language that they can later claim success regardless of the outcome. A little research often reveals that forecasters got it right once or maybe twice in a row, but the clear majority of their guesses fall flat, with investors holding the bill. I believe investors have a much greater opportunity to succeed financially and are best served by implementing a true Economy-Driven Multifactor Portfolio with its low cost broad diversification approach.
Asset Class Investing for Market Returns
Asset classes have different return characteristics and serve as the necessary building blocks in structuring a diversified, low-cost portfolio. An Economy-Driven Multifactor Portfolio uses broad market asset classes focused on global-market diversification that support a non-correlative aspect necessary for increased return opportunities. The following asset classes are integrated in structuring these portfolios: Value, Capital Preservation, Conservative, Balanced – equity /fixed income, Growth, Aggressive, and Aggressive Growth. Remember that diversification is more important than brains! A well-designed portfolio is made up of hundreds of securities, both domestic and global. Depending on your target dates (when you need to start spending your money), your holdings will be weighted heavier towards equities or fixed income securities.
The Three Factor Model of Multifactor Investing
For many decades, it has been known that over time, stocks outperform fixed income. Of course, the reason this is true is that risk and return are related. Research by economists Eugene Fama (University of Chicago) and Kenneth French (Dartmouth) has proven that returns in a diversified portfolio come from three distinct factors that account for over 90% of the return one can expect from their portfolio. These factors are (1) the Equity Factor, (2) the Size Factor (as measured by market capitalization), and (3) the Value Factor. The Three Factor Model explains how investors have an opportunity to reap greater returns by understanding the dimensions of risks and how to mitigate them in association with the structure of their portfolios. Our Economy-Driven Multifactor Portfolios carefully weigh each of these three factors by implementing them into a structured design that promotes a solid approach for successful investing.
Three Factors That Help Determine Expected Returns
Equity Factor – Stocks have a higher expected return than fixed income. This first factor asserts that exposure to the equity markets can bring about 70% of expected return in a portfolio, and if growth of assets is the goal, equities must play a prominent role in a broadly diversified, market-sector structure.
Size Factor-Small Company stocks have higher expected returns than large company stocks. This factor compares the weighted average market value of the stocks in a portfolio to the weighted-average market value of stocks on the market. Small stocks tend to act very differently than large stocks in almost all market conditions. In the long run, small stocks have generated higher returns than large stocks, although the extra return must be weighed against allowable risks.
Value Factor-Lower priced value stocks have higher expected returns than growth stocks. This third factor compares the amount of value stock exposure in relation to the market. Value stocks are companies that tend to have lower earnings/growth rates and higher book value compared to price (BtM). Said another way, the company’s total assets or value on its balance sheet is more than the value of all its outstanding stock (or market capitalization). Fama-French measured the performance of high BtM stocks (value stocks) against low BtM stock (growth stocks) and found that these two styles act very differently. In the long run, value stocks have generated higher returns vs. growth stocks, albeit because value stocks have higher risk.
Historical Returns Illustrate a Size Premium for Small and Value Stocks
(1927-2008) (Efficient Advisor study / Morningstar Principia software)
Annualized Returns
US Small Value 14.62% S&P 500 9.60% US Small Growth 12.14%
US Large Value 11.65% CRSP 9-10 11.83% US Large Growth 8.92%
Successful investors have learned that you don’t have to be entirely familiar with an asset category or sector to benefit from the long-term returns it may generate. By looking at key financial data, which is the same in any language, stocks that have specific quantitative characteristics can be identified.
Value stock gurus like Warren Buffet and Benjamin Graham differ somewhat on their method for identifying a value stock. But they generally use a mathematical formula that considers the price of the stock, the value of the company, cash flow, debt, and similar factors. In contrast, index-related funds and ETFs (Exchange Traded Funds) are typically constituted based on metrics known as book-to-market or price-to-book ratios to identify value stocks.
While many investors look for stocks with a recent history of dramatic growth, value stock shoppers look for ones that tend to be somewhat depressed in price relative to their peers. Value stocks nearly always show some signs of distress. As such, these companies aren’t among those classified currently as “growth” stocks. Instead, they tend to be positioned for greater potential future growth. And non-US companies have plenty of viable candidates too. This Three Factor Model plays an extremely important role in a properly designed Economy-Driven Multifactor Portfolio.
The Formula Matters
Keeping the main thing the main thing!
When it comes to investing, owning asset categories in their proper percentages with an eye on target use dates (when you will be spending the funds) is extremely important for successfully meeting your financial goals. Keeping your portfolio’s asset allocation structure true to course is mandatory management for success. Dissimilar price movement and market volatility constantly conspire to move your asset allocation out of its original target weighting, like the uneven scales of justice in the hands of a dictator. Correction of this imbalance, systematically reallocating assets from over-weighted categories to underweighted categories, keeps the main design allocated correctly for its originally intended purpose.
What causes portfolio imbalances?
- Over time, securities within an index can migrate from one asset class to another (such as from small cap to large cap). An index’s characteristics may be significantly different 11 months after original constitution due to security migration.
- Certain market sector performance causes them to become over-weighted for the originally intended percentages allocated for the portfolio’s pre-determined design.
Our management team frequently monitors the holdings in our portfolios to provide more consistent exposure to underlying asset classes. Remember, the goal is to develop portfolios that perform well in all economic conditions. This means that the original portfolios were structured toward that end, designed to rebound well from down cycles, and must be kept true to the original formula to be effective in all markets.
This discipline ensures against the temptation to buy high or sell low based on emotions. Reallocating to correct target weightings redeploys capital back to its proper place, thus maintaining structural integrity. This practice takes into account certain allowable tolerances, meaning we maintain correct percentages of each asset class within allowable amounts held in the portfolio. Unlike many other rebalancing strategies in the industry, we do not have an automatic default (like a 10% default trigger) but instead use different tolerances for each asset class which allows us to capture market momentum of individual sectors during volatile periods.
And finally, we come to our simple yet effective approach to the fixed income side of building our portfolios. Decades of research and real life investing proves the value of reducing portfolio volatility through holding a proper balance of equities to fixed income. Empirical evidence show us that holding varying amounts of fixed income in a portfolio adds to returns and works to the investor’s long-term benefit.
Fixed Income Investment Philosophy
- The role of fixed income is to improve overall portfolio diversification. Depending on one’s target use dates for money, its percentage will vary commensurately.
- Broadly-diversified portfolios of investment grade securities are crucial in capturing the returns of fixed income markets.
- Our philosophy follows a “variable maturity” approach in most of the fixed income portion of our portfolios, which uses the current yield curve to determine optimal maturities and holding periods.
In review: Building an Economy-Driven Multifactor Portfolio gives investors the ability to take advantage of academic-scientific research that has shown itself superior over the decades as compared against the failings of market timing, stock picking, and historical-performance investing. Please take the time to sit down with an advisor that can show you how to build such a portfolio. Learn this common sense, logical, low-cost approach to investing that boasts billions of dollars under management. Couple this approach of building your portfolio along with the intelligent implementation of Positive Return Positioning, and you will have an opportunity to see your financial goals happen, on time and unaffected by economic swings and emotional investing.
Bibliography and continued education resources for investors
Jorion, Phillippe, and Goetzmann, W., “Global stock returns in the Twentieth Century.” Journal of Finance, June 1999
Gibson, Roger C., Asset Allocation, 3rd edition McGraw-Hill, 2000
Malkiel, Burton G., A Random Walk Down Wall Street. W.W. Norton, 1996
Markowitz, Harry M., Portfolio Selection, 2nd edition Basil Blackwell 1991
Fama, Eugene F., & French, Kenneth R. “The cross section of expected stock returns.” Journal of Finance, June 1992
Siegel, Jeremy, Stocks for the long run. McGraw-Hill 2000
Bogle, John C, Common Sense on Mutual Funds. Wiley 1999
Ferri, Richard A., The Power of Passive Investing. Wiley 2011
Swedroe, Larry E., What Wall Street Doesn’t Want You To Know. Truman Tally 2004
Aware Investing, Inc. is a Registered Investment Advisory firm in the state of Colorado. These are the views of Damon Lane and should not be construed as investment advice as such. Mr. Lane highly recommends the reader seek investment counsel before implementing any of the ideas presented in this paper. Mr. Lane does not engage in rendering tax or legal advice. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. All information in this paper is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy.