Compensated Risk Factors
Good Morning Relaxing Retirement Subscriber,
Over the last couple of weeks, we’ve been discussing the factors that go into the selection of your Retirement Bucket™ investment holdings after you have set aside enough liquidity to support your withdrawal needs.
In order for your Retirement Bucket™ to remain full for the remainder of your life while providing you with the lifestyle sustaining cashflow you need, the first big question you face is what percentage will you allocate to the ownership shares of quality companies (stocks) vs. fixed income investments (bonds, money markets, CDs, and fixed annuities)?
As Nobel prize winner William Sharpe outlined in his famous Capital Asset Pricing Model (CAPM), investors who subjected themselves to the systematic risk of the total U.S. stock market were rewarded with a return that was 7.9% above the risk-free return of treasury bills since 1928.
Without getting into any other factors explaining where returns come from, what Sharpe’s CAPM demonstrated is that the biggest factor influencing returns is simply maintaining exposure to stocks as a whole.
The Next Level
Once your decision has been made to allocate the majority of your Retirement Bucket™ holdings to stocks as a whole, and live with the short-term volatility that comes with that decision, the next intelligent question is where, i.e. what will you own?
How much will you allocate to various asset classes in order to generate the overall long-term rate of return you need to earn while subjecting yourself to an appropriate and acceptable level of volatility?
In 1992, Nobel laureate Eugene Fama and Kenneth French provided groundbreaking academic research to help us answer these questions when they introduced their famous Three-Factor Model.
What Fama and French’s research concluded was that as much as 96% of the returns realized in a diversified stock portfolio are explained by their broad exposure to stocks as a whole, and their exposure to smaller companies, and companies with high book-to-market ratios, i.e. value companies.
First, note what is missing from that conclusion: market timing and individual stock selection.
In other words, after analyzing decades and decades of performance, the conclusion reached was that only 4% of the returns achieved (maximum) could be attributed to superior individual stock selection and/or the market timing of purchases and sales.
That is remarkable!
Is this what we hear in the news or in advertisements placed by large Wall Street investment firms?
Absolutely not. They tell us that it’s ALL about their stock selection prowess.
What this tells us is that, as long-term investors, our focus needs to be on the risk factors which have the most influence on returns, and to make sure that our exposure to those risk factors is properly compensated, i.e. that there is a well-documented reason to subject yourself to everything you own vs. risk factors which have not proven to be worth it.
In addition to exposure to stocks as a whole, the second big factor discovered by Fama and French is your level of exposure to small company stocks. Small companies experience more price volatility than large companies because they have fewer financial resources and less business diversification than larger companies, thus greater uncertainty of earnings.
What Fama and French demonstrated was that this increased volatility was well compensated, however, thus justifying a calculated and disciplined exposure to smaller companies.
The third big factor they discovered was exposure to value companies, i.e. whose market price is lower relative to their book value (company assets minus liabilities). Value companies are those with higher book-to-market ratios.
Fama and French illustrated that since 1928, companies with the highest book-to-market ratios (value stocks) had more price volatility, but they also had demonstrably higher long-term returns than those with lower book-to-market ratios (i.e. growth stocks).
To review, here are the principles we’ve covered over the last few weeks:
- Before investing in your retirement years, you must determine the real investment rate of return you need to earn in order for your Retirement Bucket™ to remain full while providing you with the lifestyle sustaining cash flow you need for the remainder of your life. Without a target, you have no means of determining what you should invest in.
- Determine the portion of your Retirement Bucket™ you won’t invest, i.e. funds set aside in money markets and short-term instruments to support your cash flow needs so you won’t be forced to sell in a short-term down market. This provides you with the confidence to employ the most important investing habit, i.e. confidently ignore “the noise” of daily market movements.
- Be clear on the relationship between risk and return, and determine what percentage of your Retirement Bucket™ you will invest in ownership shares of quality companies (stocks) vs. fixed income investments (bonds, money markets, CDs, and fixed annuities). This one binary decision has the greatest impact on our ability to earn the returns you need for your Retirement Bucket™ to remain full.
- Understand that not all risk is compensated the same, thus owning one stock, one idea, one industry, one asset class, etc. is not the same as owning a strategically allocated, globally diversified collection of companies.
- Fama and French’s extensive academic research demonstrates that 96% of historical stock portfolio returns are attributable to exposure to three risk factors: the broad stock market as a whole vs. treasury bills, value companies vs. growth, and smaller companies vs. large. (4% or less is attributable to superior stock selection and/or market timing) Their three-factor model begins to explain what risk factors are worth considering vs. those we should stay away from.
Stay tuned as we explore the next principle next week.
Committed To Your Relaxing Retirement,
The Retirement Coach
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(The content of this letter does not constitute a tax opinion. Always consult with a competent tax professional service provider for advice on tax matters specific to your situation.)