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?

 

The data from the preceding table makes a clear case for building portfolios that diversify across factors by showing the benefits of such diversification. Note that no matter the horizon, in every single case, the odds of underperformance are lower for each of the three portfolios than for any of the individual factors.

With this understanding, we now come to what spurred me to write this article in the first place. After reviewing the data, which makes a compelling case for diversification across factors, an argument that I often hear from older investors goes something like this: “But Larry, I don’t have 20 years to wait to earn a factor’s premium.” My answer is a simple one.

We live in a world where all crystal balls are cloudy. And even worse is that investing isn’t really about risk. It’s about uncertainty. Unlike at the poker table, where we can calculate the odds of drawing to that full house, with investing, we don’t know the odds of another event like 9/11 occurring, or the odds of having another global financial crisis like we experienced in 2008.

The best we can do is to estimate the odds of negative outcomes based on history. But we can never actually know the odds. And the research shows investors much prefer to make “bets” (that is, investments) where they know the odds over a bet where at best they can only estimate the odds. In fact, that’s one explanation for the historically high equity premium, otherwise known as the “equity premium puzzle.” Investors require a high premium to accept uncertainty.

With this further understanding, we know that the best we can do is to put the odds in our favor. And as the data in the previous table demonstrated, no matter the horizon, the best odds of success are associated with constructing portfolios diversified across factors, not concentrated in single factors (even the ones with the largest historical premiums). And total market funds have all their equity risk in a single-factor basket—market beta.

My next article will present an example of how you can build a portfolio more diversified across the factors that historically have produced premiums that have been persistent, pervasive, implementable and that come with intuitive reasons to believe they are likely to persist in the future.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

 

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