Playing the markets, skill or luck
You can beat the market. That may sound like heresy coming from a devout believer in efficient markets and an evangelist for passive investment strategies. But its true only not in the way youre thinking.Most investors believe beating the market is a game of skill won by either picking undervalued stocks or timing the market miraculously buying low and selling high. But neither of those strategies proves effective over time, even when practiced by professional managers. However, financial science offers insight into strategies that have a much higher probability of working.One Sharpe fellow Compared to Sir Isaac Newtons 17th century laws of physics, investing is a young science. Yet investment science does offer the equivalent of Newtons first law of motion: The ironclad relationship between risk and return. Stanford professor William Sharpe received the Nobel Prize for establishing this relationship some 300 years after Newton in his Capital Asset Pricing Model.This model states that a single factor the market explains changes in securities prices and investors returns. Prices of individual stocks reflect both the risks inherent in the market (systematic risk) and risks peculiar to each company (unsystematic risks, such as management acumen, demand for its products, etc.).Critically, diversifying your portfolio by holding many stocks eliminates unsystematic risk, leaving only market risk, which can not be eliminated. By withstanding market risk, investors are compensated over time with a premium over the returns that can be achieved through risk-free assets such as Treasury bills or CDs.The three-factor model As researchers examined thousands of portfolios, however, they could not explain the returns of portfolios that diverged dramatically in composition from those essentially replicating the market until Eugene Fama (University of Chicago) and Kenneth French (Dartmouth College) published The Cross-Section of Expected Stock Returns in the June 1992 Journal of Finance. They concluded that like Newtons two additional laws of motion two more factors determine portfolio returns in addition to the market exposure: Size (small cap outperforms large cap) and value (value outperforms growth).This issue goes beyond style, in which size and value characteristics go in and out of favor and expected returns eventually converge. The Fama/French configuration comports with the Capital Asset Pricing Model: Small companies are riskier than large companies due to their immaturity and shorter track records; value stocks are riskier than growth stocks because of unreliable earnings and distressed balance sheets. Value stocks typically have lower price-to-earnings ratios and are cheaper than growth stocks, the prices of which have been bid up relative to the market.Ironically, bad companies are expected to have better returns than good ones. The size and value factors reinforce the Capital Asset Pricing Model: Taking on more risk has the potential to reward investors with higher returns over time.Average annual returns 1927-2006* Large value: 11.54 percent S&P 500: 10.41 percent Large growth: 9.34 percentSmall value: 14.51 percentSmall core: 12.05 percentSmall growth: 9.33 percent*Source: Dimensional Fund AdvisorsThe myth of alphaA legion of active money managers boasts of achieving market-beating returns producing alpha by managing portfolios of selected stocks with various strategies. Whats more, a coterie of financial advisors build businesses advising their clients which of these managers based on past performance they should deploy in their portfolios.Yet, academic and industry research illustrates that, due to market efficiency and high management fees, the search for alpha has been futile. Why? Lets apply the lens of the three-factor model for clarity.In the June 2007 issue of The Journal of Financial Planning, Steven Pollock examined the performance of all actively-managed U.S. equity mutual funds with an inception prior to January 1991 and still listed with Morningstar on June 30, 2006. He compared the fund managers performance with the market and with the expected returns of portfolios with varying degrees of exposure to size and value factors, as those factors evidenced themselves throughout the period. Nearly all of what appeared to be alpha out-performance was attributable to exposure or not to the size and value premiums.Significantly, investors could have captured all of the excess return over the market by employing a passive strategy including exposure to size and value by adding small cap and value index funds to their portfolios avoiding the risk of whether their active managers (including the added expense) would accomplish this through stock selection.Managing behavior While strategic and systematic investing doesnt require a great deal of skill, it demands uncommon discipline. The small-cap and value premiums emerge and disappear seemingly at random persisting and then vanishing for years at a time. From 1995-1999, leading up to the technology bubble burst, large-cap value underperformed large-cap growth (think Microsoft and Cisco) by an average of 10 percent per year. Many investors lost their discipline and abandoned a balanced strategy at exactly the wrong time.Maintaining self-control during that period, of course, would have required a certain shyness at cocktail parties, when everyone else was boasting of their returns and your portfolio was merely chugging along. But self-control would have been rewarded in the ensuing meltdown. From 2000 to 2003, large-cap growth stocks had an average annual return of negative 11.2 percent, while large cap value lost a manageable 3.5 percent. Small-cap value soared, experiencing an average annual return of 20.4 percent over the period.Steven R. Smith, JD, CFP is the principal of RightPath Investments & Financial Planning, Inc. a fee-only Registered Investment Advisory firm in Frisco. If you have any questions or comments about the information provided in this article please contact Steve at 970-668-5525 or email@example.com. Specific investments or resources mentioned are illustrations only and are not recommendations. Past performance does not guarantee future results.Steve Smith is with RightPath Investments.