Evidence-Based Investment Insights: The Business of Investing

Evidence-Based Investment Insights: The Business of Investing

In our last piece, “Diversifying for A Smoother Ride,” we wrapped up a discussion about the benefits of diversified investing. The next step is to understand how to build your own diversified portfolio to more effectively capture long-term global market returns according to your willingness, ability and need to take on investment risks.

This in turn calls for understanding why we can expect investment returns to begin with.

With all the excitement over the market’s ups and downs in headline news, there is a key concept often overlooked:

Market returns are compensation for the financial capital you have provided to fuel a world of human enterprise going on all around us, all the time.

For example, when you buy a stock or a bond, your capital is ultimately put to work by real-life businesses or agencies. Each of them expects to succeed at whatever it is doing, whether that is growing oranges, operating a municipality or flying us to Mars. You, in turn, are not giving your money away. You mean to receive your capital back, and then some.

Investor Returns vs. Operational Success

A company hopes to generate profits. A government agency hopes to complete its work with budget to spare. Investors hope to earn generous returns. You would think that when a company or agency succeeds, its investors would, too. But actually, operational success is only one factor among many that influence expected returns.

This may seem counterintuitive. For example, even if a business is booming, you cannot necessarily expect to reap the rewards simply by buying stock in it. For one, if you buy in after a company is already thriving, you will probably pay a premium price to get in on the action. Future rewards may not be as generous as if you had bought in sooner. As we have covered before, by the time good or bad news is apparent, it is already reflected in higher-priced shares.

The Fascinating Facts About Market Returns

So, what does drive expected returns? There are a number of factors involved, but some of the most powerful ones spring from those unavoidable investment risks we introduced earlier. As an investor, you can expect to be rewarded for accepting the risks that remain after you have diversified away the avoidable ones.

Consider two of the broadest market factors: stocks (equities) and bonds (fixed income). Most investors start by deciding what percentage of their portfolio to allocate to each. Regardless of the split, you hope to be compensated for all of the capital you have put to work in the market. So why does the allocation matter?

When you buy a bond…

  • You are lending money to a business or government agency, with no ownership stake.
  • Your returns come from interest paid on your loan.
  • If a business or agency defaults on its bond, you are closer to the front of the line of creditors to be repaid with any remaining capital.

When you buy a stock…

  • You become a co-owner in the business, with voting rights at shareholder meetings.
  • Your returns come from increased share prices and/or dividends.
  • If a company goes bankrupt, you are closer to the end of the line of creditors to be repaid.

In short, stock owners face more risk and uncertainty. They may not receive an expected return, or they may even lose their investment. This is one reason why investors generally demand higher returns from their stock holdings than from their bond investments, and why stock markets have generally delivered higher returns than bonds over time. However, there are exceptions. A junk bond in a dicey venture can be as risky as any stock holding.

This outperformance of stocks over bonds is called the equity premium. The precise amount of the premium and how long it takes to be realized is far from a sure bet. That is where the risk/reward element comes into play. But comparing stock vs. bond performance over time, it is easy to identify a pair of stock return characteristics:

In aggregate, stocks have handily pulled ahead of bonds over the long-run. But they have also exhibited a bumpier ride along the way. Higher expected returns AND higher risks show up in stock market returns.

Your Take-Home

Exposure to stock market investment risks has long been among the most important factors contributing to premium returns. Academic inquiry suggests there are also additional systemic factors contributing to higher returns. Next up in our series, we will continue to explore market factors and expected returns, and why an evidence-based approach is so critical to that exploration.

This post was written and first distributed by Wendy J. Cook.


This material is intended for general public use. By providing this material, we are not undertaking to provide investment advice for any specific individual or situation, or to otherwise act in a fiduciary capacity. Please contact one of our financial professionals for guidance and information specific to your individual situation. This is not an offer to buy or sell a security.

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