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When Is A "7% Return" Not A 7% Return? Answer: Most Of The Time

By Gregg S. Fisher Let’s say you make a $100,000 investment in stocks that compounds at 7% per year (which is not far from what US equities have historically returned), and you hold onto that portfolio for 25 years without adding or withdrawing funds. For the sake of argument, let’s assume the return is constant, never deviating from 7% every year. As the Constant 7% line in Exhibit 1 demonstrates, at the end of a quarter-century holding period, the value of that $100,000 sum would have more than quintupled to $542,700. For most investors, this would be a very satisfying outcome. Click to enlarge The catch, of course, is that the assumptions we have made above are unrealistic. Aside from certain cash equivalents, no investment will grow at exactly the same rate every year, and the riskier the asset (e.g., stocks), the greater the volatility. To simulate the real world, we ran five randomized trials (all depicted in Exhibit 1), all with an “average return” of 7% a year, but now adding the additional element of 14% per year volatility, or standard deviation, which is also close to the historical experience for a stock proxy such as the S&P 500 Index. Since 14% volatility, or risk, can manifest itself in many different patterns, that “average 7% return” can take vastly different paths with entirely different outcomes. Allow me to explain what I mean. Terminal Value of $900,000, $500,000, or $200,000? How can the ending portfolio value after 25 years vary from a little more than $200,000 to almost $900,000? It’s because volatility can be the investor’s friend or foe, depending on when , and how many , losses and gains occur. For instance, if large losses are encountered early in an investment’s lifecycle (as in Trial 1, where the ending value is just $228,000), they pull down the amount of funds available for growth in later years. This scenario reminds me, in a slightly different context, of a retiree led to believe that there’s little risk in the sustainability of a 4% portfolio withdrawal rate in retirement. If the investment portfolio suffers significant losses in his first few years of retirement, then he’s behind the eight ball if he intends to keep pulling out 4% of initial portfolio value (adjusted for inflation) each year to meet his cost of living. On the other hand, if large gains build up early on, there’s that much more money to compound and to absorb future losses. Trial 2 shows such a case, with a final portfolio value of $869,000 that significantly outperforms the 7% compound return. In the three other trials, two outcomes significantly underperformed the 7% compound return (Trials 3 and 4), and one (Trial 5), despite some wicked cycles, ended with almost identical wealth. The point is that the total amount of an investor’s gains and losses can vary widely since that 14% volatility, which can dramatically affect the compounding rate, can move returns either up or down (remember, in theory volatility can work in an investor’s favor every year, just as it can also work against you). Thus, a “7% average annual return” doesn’t mean much when it comes to measuring actual long-term investment returns. Harry Markowitz, a Nobel Prize winner who’s considered the father of modern portfolio theory, suggested a rule-of-thumb method to evaluate the relationship between average performance and compound return: compound returns equal the average return minus half of the variance, and that increasing the variance of returns without increasing the average return will hurt investment performance. How Much Risk Can You Tolerate? Let’s shift gears now and apply the implications of the math that I’ve just described to real-life investment portfolios. I have worked with investors now for nearly a quarter of a century. From that vantage point, I can say that there are some investors out there who would be comfortable with a portfolio comprised entirely of high-risk assets, hoping for that $900,000 outcome described in Trial 2. But I can also state that such intrepid investors are relatively few. For the great majority of our clients at Gerstein Fisher, fear of a dismal outcome overwhelms the hope for a spectacular one. Most would be content with a smooth ride that achieves the constant 7% result, rather than reaching for the $900,000 outcome fraught with risk. We understand and respect this mindset, which is why we make risk mitigation front and center for most of the portfolios that we manage. Probably the most important such strategy-a classic-is diversification . Since many different asset classes tend to move up and down at different times, holding a collection of them tends to smooth the ride for a portfolio (i.e., reduces volatility). That’s why for most investors it’s an advantage to own both stocks and bonds, both US and international stocks, both bargain-priced “value” stocks and high-flying “growth” stocks, as well as some alternative asset classes such as REITs (we prefer both domestic and foreign ones), and perhaps some gold and commodity futures. The market movements in 2016 are a case in point. For example, year-to-date through May 2, while both domestic and international large growth stocks were down nearly 1%, value stocks and bonds were up, and global REITs and gold jumped 8% and 21%, respectively. Of course, there’s a limit to how far you should take diversification, since if you owned every investable asset on earth, the returns would probably cancel one another out and you’d be left with zero. But few investors have to worry about excessive diversification; in our experience, most are not diversified enough . How much diversification you should strive for, and with what assets, very much depends on your individual financial goals (both long- and short-term), time horizon, and ability to live through trying investment times without being tempted to bail out of the markets. If you work with an investment advisor such as Gerstein Fisher, we can help you construct such an individually tailored, diversified portfolio, and coach you through the inevitable market cycles. Conclusion Long-term portfolios with the same average annual return can produce astonishingly different final wealth sums due to volatility and differing patterns of gains and losses along the way. A well-diversified global portfolio can help to reduce volatility levels and make for a smoother ride for investors. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Gerstein, Fisher & Associates, Inc.), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from Gerstein, Fisher & Associates, Inc. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Gerstein, Fisher & Associates, Inc. is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. A copy of the Gerstein, Fisher & Associates, Inc.’s current written disclosure statement discussing our advisory services and fees is available for review upon request.

Does The Size Premium Apply To Countries?

Summary A size premium has been extensively documented in financial literature and some studies have reported a size premium at the country level as well. Portfolios constructed under max-country weight strategies have achieved higher returns and better risk-adjusted performance as measured by Sharpe ratios, albeit with higher volatilities, compared to the benchmark. Max-country weight strategy suggests a potential robust portfolio construction methodology that could provide diversification benefits and improve the portfolio’s risk-adjusted performance compared to the benchmark. Since 1981, the “size premium,” or the tendency for smaller-capitalization securities to outperform their larger-cap counterparts, has been extensively documented in financial literature in the United States. Some studies have extended this research and reported that the size effect applies for country indices as well. Gerstein Fisher conducted research on the relationship between aggregate country equity market capitalizations and country-level market index returns and explored how a market-cap weighted international portfolio can be improved by limiting the weight of larger countries, such as Japan and the United Kingdom, and redistributing weights to smaller countries. For our study, we examined a capitalization-weighted basket of developed-market country indices (excluding the US) that resembles the MSCI EAFE Index. We used this index as our benchmark, and have reported country component weights of this index in the right-most column of Exhibit 1. We then limited the maximum weight of any one country in the portfolio (ranging from a 10% cap to 15%) and re-distributed that weight to all other countries according to their market capitalizations. If, after the re-allocation, any country exceeded the maximum portfolio weight, we repeated the process and re-allocated the additional weights. Exhibit 1, which provides the average exposures of each country in the various country-capped portfolios, and the benchmark over the sample period from January 1997 to July 2015 shows that this process generally reduced the weight of the two largest countries, Japan and the United Kingdom, and added the most weight to the larger of the smaller countries – France, Germany, Switzerland and Australia – resulting in a more even distribution of country weights in the modified portfolio. (click to enlarge) Exhibit 2 reports the performance of our strategy on a cumulative and annualized basis relative to the benchmark; Exhibit 3 shows results on a cumulative basis over time. As shown in both of these exhibits, all of the capped approaches have achieved modestly better cumulative and annualized returns compared to the benchmark over the period from January 1997 to July 2015. Note that this outperformance is achieved with higher volatilities (as measured by annualized standard deviations). The highest volatility (18.45%) is observed for the portfolio applying a 10% country-weight limit and the lowest (17.92%) for the portfolio applying a 15% country-weight limit, compared to 17.14% for the benchmark. Despite the higher volatilities, all capped approaches delivered better risk-adjusted performance as measured by Sharpe ratios (ranging from 0.345 to 0.373), compared to the Sharpe ratio of the benchmark (0.304). (click to enlarge) (click to enlarge) Without further research, we can only speculate about what causes the “small country effect.” The higher return may be explained by the tilts towards the value factor: we have assigned greater-than-market weights to stocks with high fundamentals relative to price and less-than-market weights to stocks with low fundamentals relative to price at the country level in the form of country max limits since smaller countries tend to have higher growth potential and less expensive equity markets. For example, Japan, a country with a relatively low dividend yield, sees its weight in the country-capped portfolios decrease by a range of 9% to 14% with respect to the benchmark. There is a trade-off associated with tilting toward small countries, however, by using this technique. The increased volatilities indicate that small markets are riskier than larger ones. But the increase in volatility is limited since by applying a max-country weight strategy we limit the portfolio’s exposure to any single country, thus enhancing portfolio diversification and lowering concentration risk. Overall, a max-country weight strategy suggests a potential robust portfolio construction methodology that could improve the portfolio’s risk-adjusted performance, as shown by increased Sharpe ratios compared to the benchmark. For more detail and the full results of our study, we invite you to read our research paper, Country Size Premiums and Global Equity Portfolio Structure . Conclusion Our research points to a possible methodology to better structure a multi-country portfolio: varying allocations to different countries based on their equity market capitalizations. As we show, re-distributing some of the weight of larger countries to smaller countries can improve an international stock portfolio’s risk-adjusted performance.

The Trouble With Momentum – And What To Do About It

Summary Growth stocks have outperformed value stocks in recent years, which is shining a spotlight on momentum. Unlike other investment factors, the momentum premium has been persistent since it was identified by financial academics in the 1990s. We believe that combining momentum with value and other factors within a multi-factor framework is a compelling way to address the challenge of tapping momentum profitably in a growth portfolio. It’s no secret that growth stocks have outperformed value stocks in recent years. For example, in the two years from September 1, 2013 to August 31, 2015, large cap growth stocks (as measured by the Russell 1000 Growth Index) returned 14.7% annualized vs. 9.6% annualized for value stocks (Russell 1000 Value Index). This pattern of outperformance has shone a spotlight on momentum , an investment factor that works particularly well in growth-stock investing. But making money by identifying growth stocks with momentum characteristics isn’t as easy as it sounds. In this column, I will explain why and briefly describe how Gerstein Fisher addresses some of the problems inherent in tilting a growth stock portfolio to momentum. Momentum: a Persistent Investment Factor First, let’s define what we mean by momentum. Momentum is the tendency for winning stocks (that is, stocks that have outperformed the market over the past three to 12 months) to keep winning and losing stocks to keep losing. First identified in papers co-authored in the early 1990s by Sheridan Titman, one of our Academic Partners, the momentum factor would seem to refute the weak form of the Efficient Market Hypothesis, which asserts that stock prices reflect all available information and that past price movements should be unrelated to future average returns. Momentum suggests that prior movements in price are in fact related to expected stock returns – that security prices essentially have memory, which students of statistics will recognize as serial correlation. Since those landmark studies in the 1990s, a number of other academic papers have established that a momentum strategy works not only in equity markets around the world (with the notable exception of Japan’s) but also in several other asset classes, including currencies and commodities. At Gerstein Fisher, we find that a momentum tilt works at least as well in our multi-factor real estate investment trust (aka REIT) portfolio as in our US and international growth equity strategies. Exhibit 1 shows the compound annualized returns from 1927 to 2014 for 10 portfolios formed on momentum (defined here as the one-year return skipping the most recent month). Investing in the highest past one-year return (i.e., highest-momentum) stocks generated a 16.9% annualized return, while the lowest decile of momentum lost 1.5% per year. Note the steady improvement in performance as momentum increases. (click to enlarge) Moreover, unlike some other investment factors identified by financial academics, momentum has remained remarkably robust and persistent. For instance, since the size premium for small cap stocks was identified in the early 1980s, it has shrunk dramatically (see my recent column for more on this phenomenon: ” Is the Small Cap Stock Premium Disappearing? “); similarly, the value premium has also sharply declined since Fama and French published their pioneering paper on it in 1992. Quite possibly, once seminal research is available in the public domain, quantitative investors target and thereby reduce the available premiums, although they still exist. But momentum seems to be different: our research shows that the strategy has remained profitable, generating a momentum premium of five to seven percentage points* even years after Prof. Titman’s groundbreaking papers in the 1990s. The Challenge for Momentum So if all of this academic and empirical evidence for momentum is present, then what’s the problem? For one thing, momentum stocks are also subject to short-term reversals, the tendency for stocks that have risen relative to the rest of the market in the last month to underperform those that have fallen relative to the rest of the market (for more on this topic, see our recently posted paper: ” Do past returns predict future returns? Evidence from Momentum and Short – Term Reversals “). In addition, the discipline and emotion-free decisions required to hold high-momentum winners and cut low-momentum losers every month are behaviorally difficult for many individual investors to make. Most importantly, there is a very large issue with turnover and transaction costs (and tax liabilities, if held in a taxable account) with a momentum growth stock portfolio. In short, without rules for controlling portfolio turnover, transaction costs will quickly devour a premium from a tilt to momentum (a monthly rebalanced, long-only momentum strategy may have a turnover of about 300%, implying a holding period of around four months). We believe that an effective approach to addressing the problem of excess turnover is by combining momentum, a so-called fast-moving factor, with value (which we may define, for instance, as a tilt to higher book-to-market stocks than the Russell 3000 Growth Index), a slow-moving factor. Combining these two negatively correlated factors in one portfolio provides factor diversification, which is a good thing since there are pronounced and different cycles to different factors. But we also find that by combining the signals of value and momentum, we can slow down portfolio trading dramatically and improve risk-adjusted performance, both relative to the index and compared to the sum of standalone value and momentum strategies-a typical advantage of a multi-factor strategy in one portfolio. We will soon publish our research on the optimum way to combine momentum and value in an academic journal. In the meantime, I invite you to read our working paper: ” Combining Value and Momentum “. Conclusion Growth stocks – and momentum – have been the source of strong performance in the stock market. The momentum premium is palpable but difficult to tap profitably in a growth portfolio. We believe that combining momentum with value and other factors within a multi-factor framework is a compelling way to address this challenge. *The momentum premium is defined as the returns of the highest 30% of large cap US stocks rated by momentum less the return of the lowest 30% of stocks rated by momentum. Data on momentum decile portfolios are taken from Ken French’s website. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.