Change the way you think

Traditional investment managers would have you believe that investing in the market requires the ability to accurately predict what will happen in the future – and they are the ones that can do it. This very premise presents a conundrum for you as an investor. If they could accurately predict which way markets will go why would they tell you?

Wouldn’t they keep this knowledge 
to themselves and profit from it personally?

The answer is surprisingly simple...it is impossible to predict the future in anything in life and investing is no different. Building an investment portfolio isn’t about guesswork; rather it is about working with the market to capture the returns that are there for the taking, based on fundamental and well researched investment principles.

Markets Work

In 1966 Professor Eugene Fama of the University of Chicago developed the efficient market hypothesis, which asserted that stock prices on any given day accurately reflect all known information about that stock. News and events that are unknown or unforseen will change this price, but as we cannot predict what will happen in the future – we cannot forecast what affect this will have on the value of the stock. By recognising that it is nearly impossible to predict 
news and events, we can see that it is impossible to predict future share prices with any long term consistency.

The conclusion from this research was that investors cannot 
identify superior stocks using fundamental information

Risk and Return are Related

Building on this and other research, Fama teamed up with Ken French and in 1992 they developed the ‘3 Factor Model’. They found that in order to generate higher returns, an investor must be willing to take higher risks. The level of risk that each person takes will depend on their own personal preferences, but it is important to distinguish between speculation and risk. Speculation in most cases involves the next ‘hot’ stock or sector and is always based on opinion.

Risk, on the other hand, is based on compensating an investor with a higher return by taking 
a higher risk. This theory is based on three well documented and researched principles.

1. Market risk - shares are riskier than Bonds (or cash); therefore, they offer higher expected returns as a reward.
2. Small company risk - smaller companies are riskier than larger companies; therefore, they offer a higher expected return as a result of taking this higher risk.
3. Price risk - lower priced, or ‘value’ stocks’, which are out of favour for one reason or another offer higher expected returns compared to ‘growth’ stocks, again as there is a higher risk in investing in these stocks.
   

Based on this ‘three factor’ approach an investor can raise their expected return by increasing the proportion of stocks relative to bonds or cash; to small stocks relative to large stocks; and value stocks relative to growth stocks.

Diversification

Before Fama & French there was Harry Markowitz who in 1952 developed the principles of Diversification and Modern Portfolio Theory. Diversification reduces your exposure to random and unpredictable forces that can wash away your returns, while ensuring you are capturing risks that deliver a reliable return. To put it another way, diversification reduces the volatility of your returns to not only make the ride less stressful, but to also boost your returns. This research won him the Nobel Prize for economics in 1990.

Bringing it all together

By combining all of this research, portfolios can be created that, over the long term, will produce returns in excess of the market. The table below shows the performance of each asset class, 
a balanced portfolio of these asset classes and a balanced portfolio of these asset classes further split into the three factors. 


* past performance is no guarantee of future returns

Notice firstly that both of the balanced portfolios have a significantly lower risk in comparison 
to the underlying share and property indexes. This is diversification at work, exposure to all asset classes has smoothed the returns over time.

Secondly, the three Factor portfolio has produced a return that is greater than the sum of its parts.
This is due to diversification and maintaining a disciplined strategy, including rebalancing annually.

Thirdly, and most important, is that the three Factor portfolio was able to outperform the index portfolio by 20 per cent, while only increasing the overall risk by 4 per cent.

Make the Change

Generating this excess return is not about luck, timing or using the right advisor. It is about diversification, discipline and risks worth taking.

To find out how you can achieve long term outperformance contact Daniel Minihan on +61 3 9614 4444 dminihan@moorestephens.com.au.