How Smart Investors Can Profit Safely with 'Riskier' Stocks

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If you're like most investors, you are using a broker or investment adviser who is recommending some or all of the following:
  • Market timing.
  • Individual stocks or bonds.
  • Actively managed mutual funds, where the fund manager attempts to beat a designated benchmark, such as the S&P 500 (^GPSC).
  • Alternative investments.
  • Variable annuities.
  • Equity indexed annuities.
  • Private equity deals.
  • Principal protected notes.
  • Currency trading.
  • Commodities trading.
As Dr. Phil would say: How's that working for you?

Apparently, not well. According to one analysis, the average investor earned annualized returns over the last 20 years of a little more than 2 percent. They would have done better in risk-free three-month Treasury bills.

What Economists Have Learned About Risk

What if, instead of pursuing these losing strategies, you understood the factors that really explain the relationship between risk and return for investors? In 1992, Nobel laureate Eugene Fama and his co-author, Kenneth French, first explained some of those factors.
  • The most important is the percentage of your portfolio invested in stocks compared to the percentage of your portfolio invested in bonds.
  • The second is the amount of small-company stocks (where the market value of outstanding shares is below about $2 billion) in your portfolio.
  • The third is the amount of value stocks (where the stock price is low compared to its fundamentals, such as sales and earnings) in your portfolio.
Subsequently, academics have found three additional factors that further explain differences in the returns of diversified portfolios. These factors are momentum, profitability and investment.

%VIRTUAL-pullquote-I am not suggesting you allocate 100 percent of your assets to stocks in these riskier equity asset classes.%Here's the bottom line: a portfolio tilted toward small and value stocks is likely to outperform a portfolio without this tilt, over the long term. Classic financial theory posits that small and value stocks are riskier asset classes than large and growth stocks. Investors have been rewarded, over the long term, for the additional risk of investing in them. There is a behavioral school, however, that believes the value premium is at least partially, if not totally, a result of investors persistently overvaluing growth stocks and undervaluing value stocks.

I am not suggesting you allocate 100 percent of your assets to stocks in these riskier equity asset classes. However, intriguing historical data indicates that portfolios holding mutual funds consisting only of globally diversified small and value stocks permit investors to lower their overall allocation to stocks, while still achieving returns comparable to portfolios with significantly higher equity allocations.

Mutual Funds May Make It Easier

While the data on the historical outperformance of small and value stocks over the long-term is compelling, there can be prolonged periods where large-cap stocks outperform small caps, and value stocks underperform growth stocks.

Structuring a portfolio to take advantage of this academic research is not uncomplicated. You should consider using an adviser familiar with the data and experienced in doing so. But if you are a committed do-it-yourself investor, here are some funds I discuss in my book, "The Smartest Portfolio You'll Ever Own," that you might want to check out:
  • Vanguard Value Index Admiral Fund (VVIAX).
  • Vanguard Small-Cap Value ETF (VBR).
  • iShares MSCI EAFE Value ETF (EFV).
  • iShares MSCI EAFE Small Cap ETF (SCZ).
To learn more about the research that supports tilting your portfolio toward riskier equity asset classes, you can find it in my book and in a book by my colleagues Larry Swedroe and Kevin Grogan, "Reducing the Risk of Black Swans: Using the Science of Investing to Capture Returns with Less Volatility."

Investing is not guessing. While there are no guarantees, you owe it to yourself and to those who depend on you to make investment decisions based on sound evidence. Your goal should be to formulate an evidence-based plan, and then have the discipline to stick to it. The first step in implementing your plan is to ignore most of the financial news, which is filled with many emperors, all with no clothes, peddling a predictive expertise that does not exist.

Daniel Solin is the director of investor advocacy for the BAM Alliance and a wealth adviser with Buckingham. He is a New York Times best-selling author of the Smartest series of books. His latest book is "The Smartest Sales Book You'll Ever Read."
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