Before concluding, it’s important you understand we cannot be certain of the investment risks (the odds of negative premiums) we have been discussing. That should make us less confident about earning premiums, meaning the odds of not earning the premiums may be higher than our estimates.
In other words, at best we can only estimate the odds of experiencing negative premiums—we cannot know them. That helps explain why the premiums have been so large. Investors don’t like uncertainty and demand large ex-ante premiums as compensation. They dislike even more owning assets that tend to do poorly during bad times, when their labor capital is put at risk. And that’s exactly when the three premiums tend to turn negative. Together, these two issues provide the explanation for the large size of the three risk premiums.
Two more important points we need to cover both relate to the diversification of risk. First, the odds of earning the premiums are based on portfolios that are highly diversified. For more concentrated portfolios (like those of the typical actively managed fund or the typical individual investor buying individual stocks), uncertainty about outcomes is higher. That is another reason why active investing is called the loser’s game.
Second, there is very low correlation of the three risk premiums. From 1964 through 2017, the annual correlation of the size and value premiums to the stock premium has been just 0.26 and -0.25, respectively, and the annual correlation of the size and value premiums is close to 0 (0.02). That makes them effective diversifiers of portfolio risk, a type of diversification not achieved by investors whose portfolios are limited to total market portfolios.
This is an issue that many find difficult to understand. Here is a brief, and hopefully helpful, explanation. 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.
The bottom line is that when developing your investment policy statement, you must be sure that your portfolio doesn’t take 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. The appropriate warning is that 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, you will be unable to keep your head while all about you are losing theirs, and it’s far more likely your stomach will take over. And I’ve yet to meet a stomach that makes good decisions. The result will likely be that your well-developed plan will end up in the trash heap of emotions. Forewarned is forearmed.
Next, we’ll take look at the two premiums related to bonds: term and default.
Note: Data presented in this blog is from Kenneth French’s website.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.