Have you begun to fret that slow growth could stall your escape from work like custard in a jet engine? Then, like me, you’ve probably also wondered if there’s any way of speeding things up a little.

We’ve talked about saving more and spending less, and we know that jacking up your allocation to equities exposes you to greater risk. So now let’s consider an alternative approach: the potential to earn more from return premiums.

In the same way that we invest in the broad stock market over government bonds because we expect a greater return in exchange for the stomach acid (the equity return premium), certain types of equities may offer even higher returns as a ‘cheers, then’ for bearing risks beyond the market risk, or for exploiting persistent behavioural anomalies that seem rooted in human nature.

We’ll take a deeper dive into the expected return and diversification benefits of each premium in follow-up posts. For now, I’m just going to quickly map out the territory we’re exploring.

Also note the way I keep labouring the term expected return.

Although each return premium has been known to academics and investors for decades, there is no guarantee that the beneficial effects will continue to persist or offer the same froth on your returns as in days gone by.

Market risk – beta

The performance of the stock market obviously has an impact on most stocks. If the stock market tanks due to economic woes then it’s logical that the share price of a car manufacturer will fall too, as people buy less cars in a recession.

Beta is the measure of a stock’s riskiness1 in comparison to the overall stock market. If the stock market falls and a stock drops in lock-step then its beta is said to be 1.

If a stock is less sensitive to the movement of the market then it will have a beta of less than 1.

A utility company is an example of a low beta stock. People still need to keep the lights on when times are tough (so the share price is unlikely to swan-dive during a crash) but they don’t go all Jean Michel-Jarre when the green shoots show (hence the share price is sluggish when the market rises).

A high beta company2, conversely, amplifies stock market vibrations.

There is little argument about beta and we’d expect 70% of a diversified portfolio’s returns to come from this source, according to academic giants Fama and French.

But beta isn’t the only known return premium we can turn to. Several others have the potential to boost our rake, over the long term, if we overweight them in our portfolio…

Size

We’ll start with an easy one that you’ve probably heard of. Small companies (small caps) are inherently riskier than big companies (large caps) so investors demand higher expected returns to compensate.

A small cap firm may be:

• Gobbled up by a larger competitor.

• Ruined by misfortune (e.g. failure to secure a patent).

• Run into the ground by an idiot manager.

• Fall foul of any number of threats that a bigger company could ride out.

Size is measured by market capitalisation (market cap), but just how small is a small cap? Is it worth £1 billion? £500 million?

There is no consensus, but looser definitions tend to dilute the premium, which is already the weakest of the bunch.

Value

Value stocks are companies whose star is fading. While fast-moving growth companies wow investors with their uncoiling potential, value stocks have lost their lustre. They’ve taken some knocks and look like they’ll struggle in future.

Value companies are likely to have more:

• Debt.

• Dividend volatility.

• Earnings risk.

• Production capacity that’s hard to cut in a crisis.

Some academics believe the value premium persists because investors demand a greater return before they’ll risk taking on a potential basket-case.

Others believe that investors consistently undervalue weak-looking stocks.

Momentum

Momentum is the financial epitome of ‘everyone loves a winner’. It’s the effect of rising stocks continuing to rise and stuttering stocks being cast further into the pit of despair.

Momentum strategies work by buying recent winners and selling off the losers.

Human behaviour rather than risk is thought to explain the momentum premium. People tend to follow the herd and respond to news slowly rather than instantaneously.

Volatility

Portfolios consisting of low volatility (or low beta) stocks have been shown to deliver similar returns to the overall market but with up to 30% less risk.

Low volatility portfolios tend to go large on turgid stocks like utilities and non-durable goods while weeding out racy technology and manufacturing bets.

The upshot is that low vol strategies are resilient during times of trouble (see the beta section above) but underperform when markets sizzle. Over the long term, the low volatility premium flicks the Vs at the idea that you’ve got to choke down more risk to earn more reward.

Why should this be? Once again, investors are their own worst enemy, clamouring for the winning lottery ticket among high beta stocks no matter how unlikely it is that they’ll discover the next Google.

Liquidity

The liquidity premium is earned for taking on the risk of stocks (or bonds) that can’t be shifted in a hurry when you need to staunch a loss.

Yawning bid-offer spreads and low daily trading volumes are tell-tale signs of poor liquidity.

The liquidity factor is strong in small cap and value stocks. The premium increases during times of crisis as takers of less liquid stocks can charge an arm, a leg, and a kidney to desperate sellers.

Gross profitability

This premium is fresh out of the gate and makes hay from the seemingly bleeding obvious – namely that profitable firms produce significantly higher returns than unprofitable ones. Returns that are right up there with the value premium, and which may reveal that investors undervalue firms that are investing in jam tomorrow, not jam today.

Profitability latches on to a firm’s gross profits-to-assets ratio. It seeks to uncover firms whose products sell for much more than they cost, but whose raw quality may be masked because of high investment rates that lower their net earnings.

Essentially, these firms are investing a high proportion of their earnings in R&D to enable them to succeed in the future, but are penalised because they deny investors juicy earnings now.

Profitability tends to suffer less in downturns and is complementary to value.

Factor flirty

Other return premiums can wink in and out of existence but the factors above are widely recognised and haven’t yet been worn away by investors flocking to them like tourists up the steps of Machu Picchu.

So how can passive investors exploit return premiums? How big are they? How risky? How do I incorporate them into a risk-factor portfolio?

These are questions you can find the answers to by clicking on the links above.

Take it steady,

The Accumulator

1. Or a fund’s or a portfolio’s exposure to the market. [↩]
2. Where beta is greater than 1. [↩]

Good reads from around the Web.

You almost got to hear me this week – as in you almost got to hear me waffling on in real-life, as well as via this regular Saturday ramble.

I know! Calm yourselves, there’s still Countryfile to look forward to.

The grand occasion nearly happened because I was nearly featured in a radio broadcast that nearly looked at investing in ISAs in the light of the US stock market highs.

Alas, something more exciting than me and my views turned up, and ISAs were dropped.

That’s show business!

Number cruncher

While some of you may consider it a new low for the loved but troubled Beeb that it’d invite me onto the airwaves, I was flattered and a bit thrilled.

The BBC!

On the other hand, I was all set to push back against the basic premise – that it was ISA season, and with the stock market on a tear we should be carefully considering where to invest our money.

Obviously I’ve got nothing against investing, nor the careful consideration of it.

But should anyone be thinking about it today, because the US Dow Jones index has hit a new high? Should we be putting money into equities – or not – because markets have rallied? Should we be contemplating our ISAs every March?

No, no, and no.

Most people should have a multi-year investing plan that is broadly market neutral. More active investors might try their hand at tweaking their allocations based on what they guess are the underlying valuations, but nobody should be investing because some number is higher today than yesterday. Most people will be better off ignoring all the headlines entirely, and going fully passive.

As for ISAs, you should open them on 6 April – the first day you can – rather than lose the benefit of a year’s tax-free compounding by waiting until the 5 April deadline.

No head for heights

And what about those new highs on the Dow?

While I set up Monevator partly to help people understand that non-events like this are made into a big deal by the fund management industry with products to push, I’d be a liar if I said I was immune.

Physician, heal thyself, and all that.

So sure I noticed the new high. As a partial stock picker (for my sins) I’ve also noticed many all-time highs being made by individual shares, too.

However any emotional reaction is short-lived when I remind myself:

• The indices are not inflation-adjusted

• Most indices do not account for dividends

• I didn’t put in all my money at either a peak or a trough

• Attempts at market timing have relentless destroyed average returns

You don’t believe me, despite my credentials as a blogger who was almost on the radio?

[continue reading…]

You’d think we’d know better by now. Unlike our forefathers who traded houses for tulips and bought US railroad stock on hock, we’ve got behavioural finance to remind us our caveman brains go all Harlem Shake when trying to weigh up risk and return.

But no, even now there lurks inside each of us a Jekyll and Hyde investor, itching to run with the herd, to jump off a cliff, and to generally get emotional about what should be the rational business of investing.

And so risk in investment swings from meaning the fear of losing money to the fear of missing out – just like it did 100 years ago, and 300 years before that.

In a deep bear market, all the talk is of capital preservation. Having lost their shirts, investors fear losing their pants.

In contrast, when markets hit new highs you’ll hear far more about the risks of missed opportunities. The foolish chase hot shares and funds, and may even abandon their asset allocation altogether.

You say risky, I say risqué

The start of 2013 was a case in point. In just four years we’d gone from a stock market crash – and talk of the death of equities, of buy-and-hold investing, and of capitalism itself – to a roaring bull market.

It seemed that almost overnight many more people agreed that cash was trash, bonds were in a bubble, and equities were the only game in town. Yet precious few of these voices were heard when shares really were cheap.

Worse, such opinions seldom come with even a nod to individual circumstances.

• If you’re 25 and you will invest regularly for the next 30 years – and if you’re made of stern stuff – then a 100% equity strategy may well be the way to get started.

• If you’re 55 and you’ve done most of your saving, being 100% in equities is probably not for you, not matter how crummy the alternatives.

Your aim in investing should probably not be to try for the maximum possible return – or even the most likely maximum return.

Your aim is to meet your investment goals. The big risk is you don’t.

Beta not pay too much attention

Even those two different uses of the word “risk” – of losing it and of missing out – barely begins to cover risk’s many guises when it comes to investing.

For example, to academics the upside and downside risk of a share is treated as the same thing. When they say risk, they are talking about how far shares or other assets have previously moved up or down in price terms, compared to the market – something we might instead call volatility.

This academic idea of risk (called beta) is extremely useful when you’re neck-deep in theoretical portfolio construction.

But even if you believe market efficiency underpins all our investing choices, in my opinion their notion of risk is not of much practical use, whether you’re a passive investor working out a retirement plan or a value investor looking for bargains.

Passive investors should be more interested in asset allocation and the likely range of potential returns over the long-term – and in the prospects of falling short of their goals.

And value-minded stock pickers?

We should laugh at the proposal that Sainsbury shares at 240p in 2009 were a higher risk investment than at nearly 600p in 2007, whatever the academics say.

Time, investment, and risk

There are myriad other kinds of risk in investment – from currency risk to political risk to interest rate risk.

But the main one we’re interested in is the risk of permanently losing money.

Here academic notions of risk as volatility can make peace with a more common sense idea of risk as the chances of living off baked beans in your old age because you blew your pension spreadbetting.

The academic sort of risk – volatility – increases over time. But the deviation of your annualised returns versus those you expect based on historical precedent tends to decline over time. The UK stock market has fallen 20% or more in a year several times, for instance, but it’s never delivered a minus 20% annualised return over a decade, or anything like it.

This graph from Barclays Capital makes the point clearly:

Note how the range of returns decreases the longer you hold

The longer you hold a basket of shares, say, the more confident you can be of achieving the expected returns.1 Investing in shares is less risky over the long-term, than it is in the short-term.

This is why we’re advised to reduce (not eliminate!) the amount we have invested in the stock market – the riskiest asset over shorter periods – as we age, and to increase the proportion of less volatile assets like cash and bonds. We simply have less time ahead for the superior returns we expect to earn from shares (on average) to compound and outpace their year-to-year volatility, and so we can’t be confident of getting the return we’re banking on.

Note this doesn’t mean share prices, say, won’t keep going up after you sell a few. The stock market was doing its thing long before you arrived and it will trundle on long after you do. It’s a tool, not a competition.

It also doesn’t mean that my 70-year old mother and I can’t agree that, for example, the stock market looks good value whereas bonds seem expensive.

But it does mean the damage done if we’re both wrong is potentially far greater for her than it is for me, if she ignores the rules of thumb about asset allocation and holds the same proportion in equities as I do.

I have time on my side. She does not.

Don’t risk losing sight of your goals

I’ve had spirited discussions on Monevator with readers who were all-in cash, others all-in equities, one or two who were all-in emerging markets, and even one who was 100% in gold.

All the individuals concerned are articulate, personable-sounding folk that I enjoyed arguing the toss with. But obviously they can’t all be right, given that their positions contradict each other.

Luckily, being right or wrong is a risk you don’t have to take.

By all means favour some asset, sector, or geography if pure passive investing isn’t your game. But be very wary of betting the farm, especially if you’re closer to the end of your earning years than the beginning.

At some time or another, all asset classes and stock markets around the world have delivered unexpectedly terrible returns for years on end. You only live once, and I doubt you’re here to discover how it feels to be all-in on the next Japan.

By diversifying across assets and countries – and by not going entirely in or out of cash, bonds, equities, gold, property or anything else, even when you suspect you’re slightly reducing your returns by doing so – you can make sure that the all-in-a-sinkhole feeling is somebody else’s fate.

Howard Marks puts it very well in The Most Important Thing, his wonderful book on investing:

We may have an idea which one outcome is most likely to occur, but we also know there are many other possibilities, and those other outcomes may have a collective likelihood much higher than the one we consider most likely.

[Given this] we have to practice defensive investing, since many of the outcomes are likely to go against us.

It’s more important to ensure survival under negative outcomes than it is to guarantee maximum returns under favourable ones.

True, I guarantee that by diversifying you won’t win – not in the very narrowest sense of the word.

Some particular slice of some asset class or another will be the top performer over the next decade. If you’re diversified, you might well own a bit of it. But someone somewhere will own nothing else.

Putting up with the boasts of the reckless few who bet everything on black and won (or who claim they did) while remembering the silent losers who went all-in on the wrong horse is all part of the challenge.

But my idea of winning investment starts with avoiding losing, and with always remembering why I began investing in the first place.

1. You can never be entirely confident. Stock markets sometimes get nationalized. Governments default. Cash falls to hyper-inflation. [↩]