Investment Principles

Here are some basic principles that provide us with a framework for making investment decisions.

In 1952, Markowitz won a Nobel Prize for his study showing (among other things) that diversification reduces risk.

Diversification is the name used for the old adage, “don’t have all of your eggs in one basket”. There are four basic asset classes that you can include in your portfolio. These are shares, property, fixed interest and cash. When interest rates are rising, share prices are often falling, so one part of your diversified portfolio might be losing value while the other part might be gaining value.

By including each of these asset classes in your investment portfolio, you will reduce risk and volatility. Studies have shown that a diversified portfolio can produce higher returns with less volatility than you would have received if you invested only in any of the component parts.[1]

In 1965 Samuelson won a Nobel Prize for his study showing that Market prices are the best estimates of value, price changes follow random patterns and future share prices are unpredictable.

If someone advises you to invest in a particular company share, they are saying to you that the value of this company will increase more than the value of other companies. Effectively they are predicting the future. For every person that buys a company share, someone is selling it.

Nobody knows when markets will go up and when they will go down. Do you know what the share market will do tomorrow or next week?

A fundamental principle of investment is that risk and return are related. We regard an investment in government bonds as a risk free investment (on the basis that the government will not default). When we invest in shares, we are taking more risk and investors expect to be rewarded with a higher return as compensation for higher risk. This higher return over the risk free return is called the market premium.

By measuring risk, we can quantify the return we expect. How you expose your investment portfolio to risk in the different asset classes is the most critical decision you make in determining the return you can expect. If you invest in the whole market using, for example an index fund, then you will expect the market rate of return. The only way you can achieve a higher return is to accept a higher risk.

The key to an efficient investment portfolio is in making sure that you are rewarded for the risk that you take. Out of 20 investment portfolios that I have recently measured (from 20 different advisers), I found that 19 of them were receiving less than the market rate of return but were taking higher than market risk. These were inefficient portfolios because they were taking unrewarded risk. The following diagram illustrates this point.

Managing risk is the key to investment success. You can’t manage risk if you don’t measure it.

In 1990, Brinson, Randolph & Beebower published a landmark study, Determinants of Portfolio Performance.[2] Over a 10 year period they studied 91 US Pension Funds with diverse portfolios.

They found that the market timing decisions (whether to be in or out of the market) accounted for 2% of the variance in returns, the stock selection decisions (which shares to buy or sell) accounted for 4% of the variance in returns and the remaining 94% of the variance in returns came from the asset allocation decisions (how much is in different classes of asset).

Source of the contribution to the variance in returns of diversified investment portfolios.

It is interesting to observe that the global investment industry spends most of its time, money and energy in market timing and stock selection knowing that this only accounts for 6% of the variance in returns. The logical approach is to accept that nobody can predict the future and spending most of your time on the decisions that are proven to contribute the least to the investment return, does not make sense. Better to be expert at asset allocation because this is where the most variance in return is produced.

In 1992 Fama & French produced their landmark paper on the Multifactor asset pricing model & value effect.[3] They found that three factors explained most of the return of stock portfolios.

Stocks are riskier than government bonds therefore investing in stocks will deliver a higher return. The stockmarket has an expected premium over government bonds.

Small companies are riskier than large companies and therefore have higher expected returns (Banz 1981).

Stocks with a high BtM ratio are generally “distressed” stocks and therefore carry higher risk and this means higher expected returns. These stocks are also referred to as “value” stocks.

This leads to a simple view that to achieve above market returns in a stock portfolio;

The following table illustrates how value and small capitalisation stocks have outperformed the market in the UK, Europe and the USA over time. Similar observations have been made in other markets.

Fama & French added a further two factors to their pricing model to account for the fixed interest effect.

The Maturity Factor - Longer-term fixed interest investments are riskier than shorter-term fixed interest investments.

The Default Factor - Fixed interest investments of lower credit quality are riskier than fixed interest investments of higher credit quality.

Consequently fixed interest is best kept short in maturity and high in credit quality so the risk exposure of the portfolio can be increased in the equity markets, where expected returns are higher.

As we learned earlier, decisions about which stocks to buy or sell or whether to get into or out of markets, contribute little to the variance in returns but the asset allocation decision has a major impact. This is why it is important to understand the risk and returns of different asset classes and to use this data to model and construct investment portfolios that efficiently capture the returns of these asset classes.

A number of fund managers provide managed funds that are designed to capture the returns of classes of assets. For example, you can invest in funds that capture the returns of small company stocks in the Australian market. These funds don’t decide which stocks they should buy or sell (as active managers do), they simply replicate the effect of all small stocks in the market and you can capture the return of small company stocks as an asset class. Because these fund managers are not actively trading, the transaction costs and taxation implications are minimised and the cost of funds management is reduced.

By constructing portfolios based on capturing the returns of different asset classes you can build more efficient portfolios and manage the risk and the return. You can also reduce the cost of the portfolio.

The alternative is to build actively managed portfolios where advisers and fund managers are constantly trading and attempting to predict the next winning investment or timing the market. My observation is that these are generally inefficient portfolios that tend to under perform the market and often take higher than market risk. They are generally high cost portfolios, particularly after taxation.

[1] The rewards of multiple-asset-class investing Roger C Gibson Journal of Financial Planning; Mar 1999; 12, 3; ABI/INFORM Global

[2] Source: Study of 91 large pension plans over 10-year period. Brinson, Randolph & Beebower “Determinants of Portfolio Performance” Financial Analysts Journal, Jul-Aug 1986 and “Revisiting Determinants of Portfolio Performance: An Update” 1990.

[3] Fama, Eugene F. and Kenneth R. French, 1992. The cross-section of expected stock returns. Journal of Finance 47 (June): 427-465

[4] The "BtM" is the ratio of a firm's book value of equity to its market value of equity. Book value of equity is determined by the firm's accountants using historic cost information. Market value of equity is determined by buyers and sellers of the share using current information. A high BtM ratio indicates that the book value per share is high relative to the share price.