Early in our marriage, my wife and I discussed the importance of saving for the future. While we both agree that we need to have some emergency savings in the bank, when it came to long-term savings (i.e. retirement money), she tended to lean toward the phrase “Cash is King” and that long-term savings should be cash in the bank. My philosophy leaned much more toward the stock market.
When I brought this idea up to her, she would typically share her philosophy on the stock market which was: the stock market is nothing more than a Las Vegas casino – you are simply gambling and never know who will be winners or losers. Over time we found compromise in our retirement savings philosophies. A large part of this compromise was respecting each other’s valid concerns.
Eventually we determined that in order to better prepare for a future retirement, we would need to invest in the stock market. However, we did not simply throw darts at a stock chart to determine our investments. Nor did we listen to people who had a “system” to “consistently beat the stock market”.
Over years of studying the stock market and performance of investments, I was led to the work of Nobel prize winners Eugene Fama and Kenneth French. These two college professors researched the dimensions that drives investment returns. In order for something to be considered a “dimension of expected return”, any identified premium must be:
- Sensible
- Persistent
- Pervasive
- Robust
- Cost-effective
Through their studies, they determined that, for equities, there are four “dimensions of expected return. The four dimensions are:
- Market (or Equity Premium) – Investing in stocks will generate a premium versus purchasing bonds.
- CompanySize (or Size Premium) – Generally small company stocks generate a premium when compared with large company stocks.
- Relative Price[1] (or Value Premium) – Value stocks will generally generate a premium when compared with growth stocks.
- Profitability[2] (or Profitability premium) – highly profitable companies generate a premium when compared with low profitability companies.
As a result of learning about these dimensions of expected return, we modified our retirement savings methodologies to lean toward these dimensions. This does not mean that someone should only have their investments in small companies that are highly profitable and have a low price-to-book ratios. This simply means that someone’s equity investments should consider the dimensions of return in their investment methodology/allocation. The following chart provides historical premiums and returns of the dimensions identified above:
As identified above, for US stocks from 1928-2019, the Company Size premium generated an annualized return (premium) greater than simply investing in large stocks of more than 2 percent per year. Similarly, from 1928-2019 US stocks annualized Relative Price premium was 3.18 percent per year while from 1964-2019 the annualized Profitability premium was 3.57 percent.
It is important to note that these dimensions of return, or premiums, are not guaranteed to be present every day, month or year, but by incorporating the dimensions into our investment portfolios, we allow academics to strengthen our investment methodology.
At Montage Financial Advisors, we strive to help people have a better investing experience. We do this by focusing on the things that you can control:
- Create an investment plan to fit your needs and risk tolerance.
- Structure a portfolio along the dimensions of expected returns.
- Diversify Globally.
- Manage expenses, turnover and taxes.
- Stay disciplined through market dips and swings.
Contact Montage Financial Advisors if you want to live life more richly. (www.montageadvisors and info@montageadvisors.com)
[1] Relative price as measured by the price-to-book ratio; value stocks are those with lower price-to-book ratios.
[2] Profitability is a measure of current profitability, based on information from individual companies’ income statements
