In our last piece, “Investment 101: Part 8 – The Essence of Evidence-Based Investing” we explored what we mean by “evidence-based investing.” Grounding your investment strategy in rational methodology strengthens your ability to stay on course toward your financial goals, as we:
An accumulation of studies dating back to the 1950s through today has identified three stock market factors that have formed the backbone for evidence-based portfolio construction over the long-run:
If you ever hear financial professionals talking about “three-factor modeling,” this is the trio involved. Similarly, academic inquiry has identified two primary factors driving fixed income (bond) returns:
Scholars and practitioners alike strive to determine not only that various return factors exist, but why they exist. This helps us determine whether a factor is likely to persist (so we can build it into a long-term portfolio) or is more likely to disappear upon discovery. Explanations for why persistent factors linger often fall into two broad categories: risk-related and behavioral.
It appears that persistent premium returns are often explained by accepting market risk (the kind that cannot be diversified away) in exchange for expected reward. For example, it’s presumed that value stocks are riskier than growth stocks. In “Do Value Stocks Outperform Growth Stocks?” CBS MoneyWatch columnist Larry Swedroe explains: “Value companies are typically more leveraged (have higher debt-to-equity ratios); have higher operating leverage (making them more susceptible to recessions); have higher volatility of dividends; and have more ‘irreversible’ capital (more difficulty cutting expenses during recessions).” A Tale of Behavioral Instincts There may also be behavioral foibles at play. That is, our basic-survival instincts often play against otherwise well-reasoned financial decisions. As such, the market may favor those who are better at overcoming their impulsive, often damaging gut reactions to breaking news. Once we complete our exploration of market return factors, we’ll explore the fascinating field of behavioral finance in more detail, as this “human factor” contributes significantly to your ultimate success or failure as an evidence-based investor.