Factors That Figure in Your Evidence-Based Portfolio

If you're a reader of our blogs, you know we're proponents of evidence-based investing: The practice of grounding investment strategy in rational methodology.

Evidence-based investing strengthens your ability to stay on course toward your financial goals by understanding and using the factors that drive investment returns.

A body of research dating back to the 1950s has identified three factors that have formed the backbone for evidence-based portfolio construction:

  1. The equity premium. Stocks (equities) have returned more than bonds (fixed income).
  2. The small-cap premium. Small-company stocks have historically returned more than large-company stocks.
  3. The value premium. Value companies—those that appear to be undervalued—have returned more than growth companies (those that are more highly valued).

If you ever hear financial professionals talking about "three-factor modeling," this is the trio of factors they're alluding to. Academic research has also identified two primary factors driving fixed-income (bond) returns:

  1. Term premium. Bonds with distant maturities (i.e. due dates) have returned more than bonds that come due quickly.
  2. Credit premium. Bonds with lower credit ratings (such as "junk" bonds) have returned more than bonds with higher credit ratings (such as U.S. treasury bonds).

Scholars and practitioners alike seek not only to understand these return-driving factors, but also why they exist. That's important because it can help determine whether a factor is likely to persist long enough to help us in our long-term portfolio.

Why do some factors persist while others fade quickly? One explanation is related to risk. Persistent premium returns often seem to be due to the acceptance of market risk in exchange for expected reward. For example, it's presumed that value stocks are riskier than growth stocks. Value companies typically have higher debt, higher operating leverage and more-volatile dividends. They also tend to have more difficulty cutting expenses during recessions.

The investment world's understanding of return factors continues to evolve. As it does, we evidence-based investors will continue to hone our strategies for most effectively capturing expected returns according to your personal goals. Indeed, in our next blog we will discuss promising factors that may help us augment our already strong, evidence-based approach.