This article continues the theme of what you can do to have a better investment experience. The starting point is understanding how long-term wealth is created through investments. Hint: it’s not through finding the right stock or an All-Star investment manager or managing to avoid market downturns.
In fact, the blueprint for investment success is simple and straightforward. However, you may have to rethink your notions about investing.
Here’s the key point to keep in mind: markets reflect a large, complex network of information, expectations, and human behavior. These forces compete to drive stock prices to their fair value.
Free market competition has a proven history of rewarding investors for the capital that they supply. Companies compete for that capital and investors compete for returns. Therefore, no investor can expect greater returns without bearing greater risk. In this way, risk and return—that is, expected return—are related. If they were not, the flow of competitive capital would quickly move to areas that produce higher returns for less risk, which would quickly regulate the risk and return relationship.
You need to understand the nature of the risk you are taking on when you own stocks to be able to achieve the returns that they are capable of providing. It’s useful to keep in mind a remark attributed to J.P. Morgan, “During stock market corrections, stocks are returned to their rightful owners.” These stock market corrections can last for very long periods of time. For example, in the US, intermediate bonds have experienced a rate of return of 2% per year on average over the last 10 years, while stocks (as represented by the S&P 500) have experienced a greater return of -2% [?] per year on average. While risk and return are related, this is not always evident in the short term: sometimes it can take many years to achieve the expected return. This is why investing is a marathon over the long-term, not a quick sprint to wealth.
Because we know that investors are rewarded in proportion to the risk they take, we must frame our portfolio decisions around risk factors in the equity and bond markets and how well we will be compensated for taking those risks. In this way, we connect our portfolios to the forces that create opportunities to build wealth over time.
That said, not all risks carry a reliable reward. Research in capital markets has helped us to identify those risks worth taking and those which are not. Although some of the research results may seem obvious—for example, stocks have a higher expected return then bonds— there was no way to verify that this was the case until data was collected and examined.
The same is true of identifying which stocks have a higher expected return: data needs to be reviewed over long periods of time, with the application of rigorous scientific controls, to be confident about the outcomes of the research.
As we build a portfolio to achieve investment success and make decisions about what kinds of stocks should be added to a portfolio to achieve the best results, research offers the following three insights to keep in mind.
First, stocks have a higher expected return than bonds. This is not to say that we should exclude bonds from our portfolio; however, to achieve a higher rate of return we need to add stocks, with the added risk they bring, to our portfolio.
The next two factors are related to how some types of stocks perform relative to others. Small companies have a higher expected return, and carry more risk, then big companies. And value companies have a higher expected return then growth companies, but this also involves taking on more risk. Value companies are defined as those companies that have a lower market value when compared to their book value.
In applying these three factors to making portfolio decisions to achieve higher returns, we need to focus on the risk factors for which we will be compensated. By increasing the exposure of a portfolio to small companies and to companies with low market prices when compared to their book prices, we can expect to achieve higher returns.
Once we have recognized the factors that contribute to increasing expected returns, we need to turn our attention to managing risks that do not increase expected returns. Avoidable risks include:
- holding too few securities,
- betting on countries or industries,
- following market predictions, and
- relying on speculative analytical tools.
Diversification is the way to mitigate all of the above risks. Although diversification cannot eliminate the risk of market loss, it can protect your portfolio from disproportionate weightings in individual stocks and better position it to benefit from the three factors we have discussed. Diversification is achieved in multiple ways: a properly constructed portfolio will diversify across individual securities, industries, countries, and risk factors. The real power of diversification is that the whole is indeed greater than the sum of the parts.
In summary, having a better investment experience depends on making prudent choices about what kinds of risk to assume. The right portfolio for investment success needs the right ingredients mixed in the right way. As the saying goes: money is like manure—not worth a thing until it has been spread around to allow for growth.
Daryn Form is a Senior Financial Advisor with Assante Capital Management Ltd. providing wealth management services to principals of family-owned and privately held companies. Assante Capital Management Ltd. is a member of the Canadian Investor Protection Fund and is registered with the Investment Industry Regulatory Organization of Canada. The information mentioned in this article is for general information only. Please contact him to discuss your particular circumstances prior to acting on the information above. The opinions expressed are those of the author and not necessarily those of Assante Capital Management Ltd. Rates are not guaranteed and are subject to change at any time without notice.