Our firm has always believed that, in the long run, investors face an enormous hurdle in trying to outpace the returns of capital markets. Through our disciplined approach to investing, one of our ongoing goals is to help clients avoid mistakes that could prove to be costly over time. Using an approach that is grounded in decades of time-tested academic research and practical application will help investors to focus on what is in their control versus what is not. Below are the main tenants we believe in when it comes to investing our clients’ assets.
Markets throughout the world have a history of rewarding investors for the capital they supply. Companies compete with each other for investment capital, and millions of investors compete with each other to find the most attractive returns. This competition quickly drives prices to fair value, ensuring that no investor can expect greater returns without bearing greater risk.
Many investors strive to time the market and attempt to predict the future. Too often, this proves costly and futile. Predictions go awry and investors miss the strong returns that markets provide by holding the wrong securities at the wrong time. Meanwhile, capital economies thrive—not because markets fail but because they succeed.
The futility of speculation is good news for the investor. It means that prices for public securities are fair and that persistent differences in average portfolio returns are explained by differences in average risk. It is certainly possible to outperform markets, but not without accepting increased risk.
Risk means opportunity
Investors are rewarded in proportion to the risk they take. Framing decisions around compensated risk factors in the equity and bond markets connects investors to the forces that create opportunities to build wealth over time.
Evidence from practicing investors and academics alike points to an undeniable conclusion: Returns come from risk. Gain is rarely accomplished without taking a chance, but not all risks carry a reliable reward. Capital market research over the last fifty years has brought us to a powerful understanding of the risks that are worth taking and the risks that are not.
Much of what we have learned about expected returns in the equity (stock) markets can be summarized in three dimensions. The first is that stocks are riskier than bonds and have greater expected returns. Relative performance among stocks is largely driven by the two other dimensions: small vs. large and value vs. growth. Many economists believe small cap and value stocks outperform because the market rationally discounts their prices to reflect underlying risk. The lower prices result in higher returns to investors as compensation for bearing this risk.
Relative performance in fixed income (bonds) is largely driven by two dimensions: term and credit. Longer-term bonds are subject to the risk of unexpected changes in interest rates. Bonds with lower credit quality are subject to the risk of default. Extending bond maturities and reducing credit quality increases potential returns, as well as risk.
With this understanding, investors can plan the total risk/return profile of their portfolios, considering how much exposure they need to target their performance goals. For example, investors seeking greater expected returns may increase their equity exposure while keeping their bond portfolio short and high-quality. Whatever approach one chooses, academic research has clarified the investment process by identifying the relevant dimensions of performance.
Diversification is essential
Successful investing means not only capturing risks that generate expected return but reducing risks that do not. In fact, over 96% of the variation in returns is due to risk factor exposure. Avoidable risks include holding too few securities, betting on countries or industries, following market predictions in areas like interest rate movements, and relying solely on information from third-party analysts or rating services. To all these, diversification is an essential tool available to investors. It lessens the impact of the random fortunes of market predictions and positions your portfolio to capture the returns of broad economic forces.
We feel investment strategies should be based on research and experience rather than on speculation. At our firm, the goal is to provide clients with the most appropriate investment plan given their unique goals and objectives for the future.
Jeremy Brenn is co-owner of the fee-only wealth management firm, Sensenig Capital Advisors. He is an active member of the Financial Planning Association and also holds the distinguished CFP® designation. He has been quoted in the Philadelphia Inquirer and other personal finance related sources. To learn more about his firm’s approach to working with business owners contact his firm at firstname.lastname@example.org or (610) 584-9700.
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1 Dimensional Fund Advisors, “Structure Determines Performance.”
2 Diversification does not ensure a profit or protect against a loss in declining markets.