Two weeks ago in the article, “Summertime and Investing is Easy,” we wrapped up a discussion about the benefits of diversifying your investments to minimize avoidable risks, manage the unavoidable ones that are expected to generate market returns, and better tolerate market volatility along the way. The next step is to understand how to build your diversified portfolio for effectively capturing those expected returns. This in turn calls for understanding where those returns actually come from.
The Business of Investing
With all the excitement over stocks and bonds and their ups and downs in headline news, there is a key concept often overlooked. Market returns are compensation for providing the financial capital that feeds the human enterprise going on all around us, all the time.
When you buy a stock or a bond, your capital is ultimately put to hard work by businesses or agencies who expect to succeed at whatever it is they are doing, whether it’s growing oranges, running a hospital or selling virtual cloud storage. You, in turn, are not giving your money away. You mean to receive your capital back, and then some.
Investor Returns vs. Company Profits
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, a company’s or agency’s success is only one factor, at best, among many others that influence its investors’ expected returns.
At first, this seems counterintuitive. It means, for example, that even if business is booming, you cannot necessarily expect to reap the rewards simply by buying stock in that same, booming company. (As we’ve covered before, by the time good or bad news is apparent, it’s already reflected in higher-priced share prices, with less room for future growth.)
The Fascinating Facts About Market Returns
So what does drive expected returns? There are a number of factors involved, but among the most powerful ones spring from those unavoidable market risks we introduced earlier. As an investor, you can expect to be rewarded for accepting the market risks that remain after you have diversified away the avoidable, concentrated 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 are still expecting 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 higher odds that they may not receive an expected return, or may even lose their investment. There are exceptions. A junk bond in a dicey venture may well be riskier than a blue-chip stock in a stable company. But this is why stocks are generally considered riskier than bonds and have generally delivered higher returns than bonds over time.
This outperformance of stocks 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’s where the risk comes in. But viewing stock-versus-bond performance in a line chart over time, it’s easy to see that stock returns have handily pulled ahead of bonds over the long-run … but also have exhibited a bumpier ride along the way. Higher risks AND higher returns show up in the results.
Exposure to market risk has long been among the most important factors contributing to premium returns. At the same time, ongoing academic inquiry indicates that there are additional factors contributing to premium returns, some of which may be driven by behaviors other than risk tolerance. In the next part of our series, we’ll continue to explore market factors and expected returns, and why our scientifically-driven, evidence-based approach is so critical to that exploration.