A stock market survival course: Part 5
Monday, December 17, 2018
This is the final article of a five-part investor’s survival course designed to give you essential information you need to succeed as an investor in the stock market. None of it is mere opinion.
Everything stated in these articles is backed by the research of well-known economists and published in leading journals of economics and finance. Each article can be read in 10 to 15 minutes.
The previous articles summarized the research indicating that while individual investors underperform the market by more than 60 percent, only about 5 percent of professional investors beat the market in a given year. Further, they are unable to match that performance in succeeding years.
Rather than trying to beat the market, you can generally obtain higher returns by buying index funds that hold proportionate shares of either the entire market — total return funds — or large representative market segments, such as an S&P 500 index fund. This achieves far greater diversification than a portfolio of individual stocks and thereby substantial reduces the risk of loss.
Associated strategies increase investor returns by lowering costs: buying ETF’s and mutual funds from the lowest cost providers (at this writing, Charles Schwab, Vanguard and Fidelity) and by holding equities rather than trading them, which lowers transaction fees and capital gains taxes.
In this last article I’ll summarize current research on the relationship between risk and return and, finally, will suggest a slight modification of the investment program advocated here that takes advantage of the market cycle.
Does Lower Risk Equal Lower Reward?
It’s long been held that there is a positive relationship between investment risk and reward — that a portfolio of higher risk equities yields higher returns.
A 2007 Federal Reserve study, for example, holds this view, which is still regularly affirmed even by generally reliable sources of market information like Investopedia: “At low levels of risk, potential returns tend to be low as well. High levels of risk are typically associated with high potential returns.”
In one way or another, a lot of stock market advice presupposes this is really so.
Surprisingly, however, as economists have enjoyed access to increasingly powerful computers enabling them to analyze vastly greater amounts of financial data, this correlation has begun breaking down.
A 2016 article by Harvard Business School’s Malcolm Baker determined that in a given period a portfolio of the 30 percent of stocks with the lowest risk factors outperformed a portfolio of the 30 percent with the highest risk factors by 5.5 percent annually.
Other recent studies confirm this, including a 2017 article in the Journal of Applied Finance, which determined that so-called “value” stocks with lower than average price to earnings ratios outperform “growth” stocks with high P/E’s.
This disconnect between high risk and high reward has been increasingly recognized by many analysts and this particular study, which was unusually comprehensive — lasting 15 years and including nearly 5,000 stocks — leaves little room for doubt. Strategies to minimize risk like those advocated in this series of articles don’t reduce returns that could have been attained with riskier strategies. On the contrary, by reducing risk you’ll increase your investment returns.
As I pointed out earlier, one easy way to reduce risk it to maximize the diversity of your investments by buying low-fee index funds. Another good way is to buy mutual funds and ETFs specializing in value stocks, stocks with solid fundamentals, but lacking in glamour and/or in a business sector active investors aren’t enthusiastic about.
These stocks are generally undervalued with low price-earnings ratios (P/E). All the major brokerages sell value funds populated with these stocks; many of them are in the brokerage’s select list and can be bought and sold without a transaction fee.
Value funds are available in different formats. Two of particular interest are those that specialize in large companies (i.e., “large value”) and small companies (“small value”). Each type has its advantages.
Historically, value funds made up of smaller companies have enjoyed slightly higher returns. It’s also arguable they propose a slightly greater risk. Here are some low-fee value funds/ETFs, by type:
- SCHV: Schwab large cap value ETF with expense ratio of 0.04 percent
- SCHA: Schwab small cap value ETF with expense ratio of 0.05 percent
- VTV: Vanguard large cap value ETF with expense ratio of 0.05 percent
Fidelity also has FVAL, a value fund with a blend of large and medium sized companies, although with a higher expense ratio of 0.29 percent. This is still relatively low. With $100,000 invested, the management fee for Schwab’s SCHV is $40 versus $290 for Fidelity’s FVAL.
The Investment Exception to the Rule
There is one circumstance where slightly higher-risk growth funds outperform value funds. It’s not as widely understood as it ought to be; during the time I managed clients’ investments I regularly used this exception to the rule to give client portfolios a performance boost.
The stock market is highly cyclical, meaning that it regularly cycles between periods of expansion and contraction. Individual cycles vary in length, but on average bull markets — periods of expansion — last about four years, while bear markets — periods of contraction — last around 12 months.
In an article not publicly available, ValueScope calculated the average historical market return for the first two years of a bull market — a rather astonishing 43 percent gain in the first year and a 65 percent total gain by the end of the second year.
Unfortunately, it’s during these same first two years in a bull market when many investors, hard-hit by losses in the preceding bear market, edge back into investing cautiously. But it’s the one time in the market when you’ll enjoy better returns from growth stocks and funds.
One conservative strategy for taking advantage of this phenomenon is to wait for the National Bureau of Economic Research to make the call. They’re conservative and by the time they announce the beginning of a new bull market, it’s probably been underway for several months.
The good news, however, is that they’ve never been wrong. To be very clear: The NBER has never declared a bull market that subsequently contracted significantly in the near term.
When the NBER declares a new bull market is a good time to switch from value funds to growth funds. Then, gradually and beginning in the bull market’s second year, begin rotating back into value funds. A conservative (and recommended) approach to this rotation is to do it at a rate that will have your portfolio predominantly in value funds again sometime around the beginning of the third year of the bull market.
Although analysts have traditionally claimed a link between higher risk and higher investment returns, recent research shows that the link doesn’t exist; that portfolios comprised of the lowest-risk stocks outperform higher risk portfolios by over 5 percent each year.
This aligns with other research showing that value funds that buy underrated, low P/E stocks substantially outperform growth funds. The one exception to this rule is in the first two years of a bull market. During that period, growth funds generally outperform value funds.
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