Determinants of Risk and Return in Stocks and Bonds

The chapter explores the factors influencing stock market outperformance, the limitations of the CAPM model, and the introduction of a new model by Fama and French. It highlights the significance of identifying merger and acquisition targets to capture a size premium and delves into the three-factor model focusing on the value factor. The conversation underscores the importance of analyzing small companies based on profitability and the impact of investor behavior on returns.

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In this episode of Investing Principles, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 1: The Determinants of the Risk and Return of Stocks and Bonds.

LEARNING: Look for key metrics, traits, or characteristics that help them identify stocks that will outperform the market.

“Intelligent people maintain open minds when it comes to new ideas. And they change strategies when there is compelling evidence demonstrating the ‘conventional wisdom’ is wrong.”

Larry Swedroe

In this episode of Investing Principles, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories Larry has developed over the 30+ years he’s been trying to help investors. Larry is the head of financial and economic research at Buckingham Wealth Partners. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.

Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 1: The Determinants of the Risk and Return of Stocks and Bonds.

Chapter 1: The Determinants of the Risk and Return of Stocks and Bonds

In this chapter, Larry looks at research that revolutionized how people think about investing and how to build a winning portfolio. The goal is to help investors learn how to look for key metrics, traits, or characteristics that help them identify stocks that will outperform the market, at least in terms of delivering higher returns, not necessarily higher risk-adjusted returns.

The three-factor model

The first research Larry talks about is by Eugene Fama and Kenneth French. Their paper “The Cross-Section of Expected Stock Returns” in The Journal of Finance focused on research that produced what has become known as the three-factor model. A factor is a common trait or characteristic of a stock or bond. The three factors explained by Fama and French are:

Market beta (the return of the market minus the return on one-month Treasury bills)
Size (the return on small stocks minus the return on large stocks)
Value (the return on value stocks minus the return on growth stocks).

The model can explain more than 90% of the variation of returns of diversified US equity portfolios. The research shows that ensemble funds are superior to individual funds. It’s better to have a multi-factor portfolio. So you could own, say, five different funds that have exposure to each individual factor, or you own one fund that gives you exposure to all those factors. The ensemble strategies always tend to do better.

The two-factor model

Larry also highlights a second model by professors Fama and French, the two-factor model that explains the variation of returns of fixed-income portfolios. The two risk factors are term and default (credit risk). According to the model, the longer the term to maturity, the greater the risk; the lower the credit rating, the greater the risk. Markets compensate investors for taking risks with higher expected returns. As with equities, individual security selection and market timing do not play a significant role in explaining returns of fixed-income portfolios and thus should not be expected to add value.

Buffett’s Alpha

Another significant academic research publication is the study “Buffett’s Alpha.” The authors, Andrea Frazzini, David Kabiller, and Lasse Pedersen, examined the performance of the stocks owned by legendary investor Warren Buffett’s Berkshire Hathaway. They found that, besides benefiting from using cheap leverage provided by Berkshire’s insurance operations, Buffett buys safe, cheap, high-quality, and large stocks. Their most interesting finding was that stocks with these characteristics tend to perform well in general, not just the stocks with these characteristics that Buffett buys. Larry observes that Buffett’s strategy, or exposure to factors, explains his success, not his stock-picking skills. Also, he never engages in panicked selling.

Larry says that investors don’t need to be stock pickers like Warren Buffett. They can simply buy stocks with the same characteristics as Warren Buffett’s stocks without doing all the research. Today, companies like AQR, Avantis, Bridgeway, Dimensional, and others use that research so that every investor can access those characteristics and decide which characteristics they want to invest in. The iShares MSCI USA Quality Factor ETF (QUAL) buys quality stocks. It has an expense ratio of just 0.15% and is highly tax-efficient as an ETF.

Luck versus skill

Academic research has demonstrated that efforts to outperform the market by either security selection or timing are improbable in proving productive after taking into account the costs, including taxes, of the efforts. For example, studies such as the “Luck versus Skill in the Cross-Section of Mutual Fund Returns” have found that fewer active managers (about 2%) can outperform their three-factor-model benchmark than would be expected by chance. That is even before considering the impact of taxes, which for taxable investors is typically the most significant expense of active management (greater than the fund’s expense ratio and/or trading costs).

Larry, therefore, recommends:

Developing a portfolio that reflects your unique ability, willingness, and need to take risks. The equity portion should be globally diversified across multiple asset classes. The fixed-income portion should be diversified in terms of credit and term risk, as appropriate.
Avoiding the use of actively managed funds. Instead, invest in funds that provide systematic exposure to the factors you seek exposure to, such as low-risk and tax-efficient index funds.
In the case of fixed-income assets (for those individuals who have sufficient assets to do so), build a portfolio of individual Treasury securities and/or FDIC-insured CDs, and for taxable accounts, AAA- and AA-rated municipal bonds that are also either general obligation or essential service revenue bonds. Doing so dramatically reduces the credit risk and, therefore, the need for diversification (which is the benefit of a mutual fund).
Having the discipline to stay the course, ignoring the noise of the markets and the emotions caused by the noise—emotions that cause investors to abandon even the most well-developed plans.

Notes

Michael Lewis, Moneyball (Norton 2003), p. 67.
Eugene Fama and Kenneth French, “The Cross-Section of Expected Stock Returns,” The Journal of Finance (June 1992).
Andrea Frazzini, David Kabiller and Lasse Pedersen, “Buffett’s Alpha,” Financial Analysts Journal (September 2018).
Eugene Fama and Kenneth French, “Luck versus Skill in the Cross-Section of Mutual Fund Returns,” The Journal of Finance (September 2010).

About Larry Swedroe

Larry Swedroe is head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.

Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.

Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.

Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.

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