The Price You Pay
If you want to earn the expected premiums, you must accept the fact that you will experience losses, no matter how long your horizon. An “expected” premium refers to the mean of the distribution of potential outcomes. Said another way, if you can’t stand the heat, stay out of the kitchen.
It’s also important to understand that we cannot be certain of the risks associated with these premiums. That should make us much less confident about earning them, because the odds of not doing so may well be higher than our estimates.
In other words, at best we can only estimate the odds of experiencing negative premiums, we cannot fully know them. That helps explain why the premiums are large. Investors don’t like uncertainty. Even more, they dislike owning assets that tend to do poorly during bad times, when their labor capital may be at risk. And that’s exactly when the three premiums tend to turn negative.
Diversification Of Risk
There are two more important points we need to cover, both related to the diversification of risk. First, the odds of earning the premiums are based on portfolios that are highly diversified. For more concentrated portfolios—such as those of the typical actively managed fund or the typical individual investor buying individual stocks—uncertainty about outcomes is higher. That is another reason active investing is called the loser’s game.
Second, there is very low correlation of the three risk premiums. The annual correlation of the size and value premiums to the stock premium has been just 0.38 and 0.09, respectively. The annual correlation of the size and value premiums is close to 0 (0.06). That makes them effective diversifiers of portfolio risk, a type of diversification not achieved by those investors who invest only in total market portfolios in their equities allocation.
It’s true that total market portfolios own small and value stocks, providing positive exposure to the premiums. However, they have no net exposure to the size and value premiums because their holdings of large and growth stocks provide negative exposure to the premiums—exactly offsetting the positive exposure provided by the small and value stocks.
Preparation Is Crucial
The bottom line is that when developing your investment policy statement, you must be sure that your portfolio doesn’t assume more risk than you have the ability, willingness and need to take. You must also be sure that you understand and accept the nature of the risks you are going to have to live with over time.
Most battles are won in the preparation stage, not on the battlefield. If you don’t understand the nature of the risks, when they do show up, it’s far less likely you’ll be able to keep your head while others are losing theirs. Your well-developed plan could well end up in the trash heap of emotions. Forewarned is forearmed.
Later this week we’ll take a look at the two premiums related to bonds—term and default.
Larry Swedroe is the director of research for the BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.