How To Improve Long-Term Returns During Market Uncertainty Using Evidence Based Investing
If you’ve been watching global equity (stock) markets over the last twelve months, you’ve probably concluded that markets are random and that no one, no matter how educated they are, can accurately predict where the markets will be a year or two from now. If that’s your conclusion, you’re correct!
The graph shown below on the left confirms what you’re feeling about short-term market uncertainty. The axis on the left shows the beginning price-to-earnings (PE) ratio value of the US S&P 500 index for each month over a 60-year period, and the bottom axis shows the gain or loss that the S&P 500 index experienced over the following 12 months from that initial date. The low correlation reflected in the first graph is historical evidence that no matter how high or low the market is valued today, no one can predict how it will perform over the next year or two. That’s the bad news, but the statistical evidence shown below on the right is far more encouraging. Using the same S&P 500 data that generated the first chart, we compared the relationship between a beginning PE ratio and the average annual return that the index earned over the following decade. The results show that buying an equity index like the S&P 500 when PE ratios are lower (lower right quadrant) is statistically likely to improve the average annual earnings on your investment over the following decade. By comparing PE ratios with their following 10-year returns, we can see that the relative price you pay for an investment today is a strong predictor of the average annual returns you are likely to earn on that investment over the next decade.
Research efforts by Nobel laureate Eugene Fama, and other distinguished professors and researchers in the field of Finance, have resulted in an overwhelming amount of evidence that there are also characteristics (“factors”) that have generated higher investment returns over an extended period. The chart below shows the average annual return premium (highlighted in blue) that the three factors of company size, relative price, and profitability have produced historically across all global equity markets.
Here’s a hypothetical example to put the power of these premiums into perspective. If you invested $20,000 per year into equity mutual funds over a 10-year period, and if those equity funds were able to generate an average of 7% per year using a factor tilted portfolio, compared to a 5% annual return using an index based portfolio, that 2% annual advantage would increase total portfolio earnings by $31,536 over that decade ($95,673 compared to just $64,137) – that’s nearly 50% more return on the portfolio!
It’s important to note that the factor premiums shown in the previous chart are NOT guarantee to materialize on a year-by-year basis. Rather, it gives us an indicator of the odds that each factor premium will exist over the next decade. To illustrate this, look at the chart shown below on the left that shows how often the Relative Price premium (Value vs. Growth) has historically occurred in the US market over a one-year period – the blue bars indicate years when Value stocks outperformed Growth stocks. Now look at the same data shown below on the right in 10-year rolling periods. Clearly, the likelihood of earning this premium, by investing in a portfolio tilted toward Values stocks, is significantly higher if you hold to this strategy over a 10-year period or longer.
The historical evidence for all three factors (company size, relative price & profitability) mentioned above shows similar results on an annual vs 10-year rolling basis, though the years in which certain premiums occur could differ. To account for this, a diversified portfolio should contain funds that are tilted toward all three factors to some extent.
The most significant mistake individual investors make when implementing an evidence based investment portfolio is to abandon the strategy based on short-term results rather than holding to the strategy based on the long-term evidence. Vanguard, Russell Investments, and other investment research firms have studied historical investor behavior and determined that working with a financial advisor over an extended period of time can improve investor returns by close to 3% on average per year (before fees). Each of these studies concluded that at over half of this return advantage comes as a result of advisors helping their clients adhere to a long-term investment plan despite the short-term volatility of the markets.
HFG Trust is committed to pursuing higher long-term investment returns for our clients through implementation of the following evidence based principles:
- Diversifying equity holdings across multiple asset classes including US, International Developed Market, and International Emerging Market stock funds
- Allocating equity investments to asset classes based on how attractive valuations are compared to their historical high and low valuation marks over a full market cycle
- Constructing equity portfolios using low cost mutual funds that improve on the performance of index funds by tilting more of their holdings toward smaller stocks, value stocks, and more profitable companies
This memorandum expresses the views of the author as of the date indicated and such views are subject to change without notice. HFG Trust has no duty or obligation to update the information contained herein. Further, HFG Trust makes no representation, and it should not be assumed that past investment performance is an indication of future results. Moreover, wherever there is potential profit there is the possibility of loss. This memorandum is being made available for educational purposes only and should not be used for any other purpose. The information contained herein does not constitute and should not be construed as an offering of advisory services or an offer to sell or solicit and securities or related financial instruments in any jurisdiction. Certain information contained herein concerning economic trends and performance is based on or derived from information provided by independent third-party sources. HFG Trust believes that the sources from which such information has be obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. This memorandum, included the information contained herein, may not be copied, reproduced, republished, or posted in any form without the prior written consent of HFG Trust.
Paul Hansen, CFP® CPA