Swedroe: Diversification For The Long Term

November 11, 2016

The table below, taken from the newly released book I co-authored with Andrew Berkin, “Your Complete Guide to Factor-Based Investing,” shows the annual premium and Sharpe ratio for the equity factors of market beta, size, value, momentum, profitability and quality. It also shows the odds that each premium will produce a negative return over various time horizons.

There are two important takeaways from this data, which covers the period 1927 through 2015. See if you can identify them:

The first is that, in each case, the longer the horizon, the lower the odds of the factor producing a negative premium. Said another way, the longer the horizon, the more likely it is that the expected will occur.

The second is that no matter how long the horizon, there is always some chance that the factor will produce a negative premium. The sole exception in the data was that there was no 20-year period when the momentum factor had a negative return. However, this certainly does not mean it can’t happen in the future. When it comes to risky assets, no matter how long the horizon, you should never treat even the highly likely as certain.

The Factor Portfolio

Now let’s consider how building a diversified portfolio of factors might impact the odds of producing a negative premium. To avoid being accused of data mining, we will build what are referred to as naive, or 1/N, portfolios.

Portfolio 1 (P1) has a 25% allocation to each of the four factors of market beta, size, value and momentum. Portfolio 2 (P2) is allocated 20% to each of the same four factors, but adds a 20% allocation to the profitability factor. Portfolio 3 (P3) simply substitutes the quality factor for the profitability factor. The period is the same we used before, 1927 through 2015. What does the data tell us? What’s the takeaway this time?

 

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