Investing is the act of setting aside our hard-earned cash with the expectation of earning a return over the long-term. All investments come with a multitude of risks, and leading theories contend that it is risk is the reason we expect investments to generate returns.
What are expected returns?
Expected returns are estimates of investment strategy performance based on the analysis of historical data and present market conditions. We use expected return assumptions to compare investments and make projections in financial plans. Actual returns are a combination of expected and unexpected returns, and unexpected returns dominate in any given year. Since the future doesn't play out the way we think it does, expected return assumptions are wrong, but we take great care to eliminate bias in our methods. Newer asset pricing models may help us identify investments with higher expected returns, but those higher returns often don't materialize. Never lose sight of the many risks involved in your investment of choice.
More Risk Implies More Returns--Sometimes
In general, we expect riskier investments to yield superior returns. Stocks, for example, are considered riskier than bonds, and stocks have higher expected returns than bonds. This relationship is a fundamental part of portfolio construction. Common investing wisdom would suggest investing more in stocks for higher returns and investing more in bonds for less risk.
Intuitively, though, we know that not all risks are smart risks. Some risks offer no reward. One such risk is called idiosyncratic risk. This is the risk that something bad happens to any single company out of the blue, such as the CEO getting hit by a bus. This risk can be effectively eliminated by diversifying a portfolio by holding a larger number of companies.
Not all risks go away simply by buying more stocks. All stocks tend to move together in response to interest rates, economic conditions, market sentiment, and more. This risk is called market risk or systematic risk, and it doesn't go away by buying more stock. Your diversification strategy would need to expect into buying into different risks, that hopefully don't all activate at the same time.
The market risk of stocks is greater than that of bonds as a whole, thus stocks have a higher expected return than bonds. Portfolios often include stocks, for their ability to grow in value, and bonds, for their ability to balance risk. That said, stocks don't always perform better than bonds, and bonds don't always balance the risk of stocks.
Traditional stock investment strategies using older asset pricing models consider only one risk, market risk, and measure it with volatility, the size of its ups and downs. In practice, we find that volatility fails to predict the relationship between risk and return in stocks. Stocks still have a higher return than bonds over the long run, but riskier stocks underperform safer ones. This has led investment advisors to treat all stocks as having the same expected return.
The Best Strategy For Most People
If you can't tell the expected returns of stocks apart from each other, you're left with only one tool in the toolbox--to diversify as much as possible. Buying broad-based index funds or total market funds can achieve the diversification goal at an incredibly low price.
The returns you get from buying total market funds are, by definition, average. This is a perfect match for the average investor. Total market funds have the added benefit of minimizing trading costs and avoiding the risk of acting on bad information.
However, if you're not the average investor, you're likely seeking an investment style that better suits you.
Modern Pricing Models Can Improve Portfolio Returns
Newer pricing models describe multiple risk factors that drive the returns of stocks. Each factor acts like a unique and independent source of compensated risk. This means that they have their own expected returns that can add to the returns of market risk. These returns can be combined to partially diversify their own risk and market risk. In short, combining multiple factors has been shown to provide higher and steadier returns than a total market portfolio or S&P 500 index funds in historical tests.
Multi-factor models have been around for decades, but are not as widely used by investment advisors. The best factor strategies have been found to work across asset classes and geographies, are robust to implementation details, and survive trading costs.
What are the factors and approaches used at Left Coast to build high-quality portfolios for our clients? They make theoretical and intuitive sense, giving us the ability to invest with conviction.
Click on the factors below to learn more.
Market Factor
Value & Profitability Factors
Size Factor
Low Volatility
Momentum Factor & Trend Following
If this is so easy, why isn't everyone doing it?
Nothing about this is easy. Implementation is difficult. Sticking to the formula can be painful. It takes high quality data and considerable effort to make any sort of active investment strategy work. Details matter. Factors can underperform for long stretches of time and push your patience to the limits. Five to ten years of underperformance is common. Trend following can lag for decades. Why would you put yourself through this? You're either really dedicated to the cause, or these risks don't bother you because you're not the average investor.
How we handle investment accounts for our clients
Total market index funds are the best investment vehicles for the average investor. Are you the average investor? Probably not. What sets us apart is that we take the time to get to know you. Chances are you aren't average.
We build custom investment strategies for every size portfolio to fit your needs, your aspirations, and your temperament. All of our investment styles are based on cutting edge published research applied to your unique needs.
If you don't have the time, interest, or inclination to spend hours of research to invest on your own, then we might be a good fit. Reach out and say hi!
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