Swedroe: Highest Expected Returns Not Always Best

November 13, 2015

Increasing Concentration

Given these two “schemes,” the methodology using the 30 percent of stocks with the lowest prices will have higher expected returns than the one using the 50 percent rule. The reason is that the value premium is basically monotonic, increasing as you go down deciles. Stocks with the highest prices have the lowest returns, and stocks with the lowest prices having the highest returns. Thus, if an investor sought higher expected returns than those available from the bottom 30 percent of stocks, they could limit their holdings to, say, the bottom 20 percent.

Taking it a step further, you could own just the bottom 10 percent. And taking it even further, you could own the bottom 1 percent, or perhaps even the single stock with the lowest price. Of course, most investors would not want to take such a concentrated risk.

In other words, there’s a trade-off between expected returns and diversification. When it comes to large value stocks, a mutual fund probably should hold, at a minimum, 200 stocks to be effectively diversified.

With smaller stocks, which tend to have more idiosyncratic risk, a mutual fund would probably want to hold several times that figure. As you increase the number of stocks, you reduce idiosyncratic risk, but you also lower expected returns. The key is to find the right balance between the two.

Idiosyncratic Risks

The same principles apply to owning U.S. stocks or international developed and emerging market stocks. Yes, you could increase your expected return today by lowering your allocation to U.S. value stocks and more heavily weighting international developed, and especially emerging market, value stocks. However, doing this would also decrease your level of diversification, increasing idiosyncratic risks. Again, we have the same trade-off.

My recommendation is to create an investment policy statement that clearly defines the amount of exposure you believe provides a prudent amount of diversification among U.S., international developed and the emerging markets. And then stay the course, rebalancing along the way.

When one asset class outperforms (and its value metrics likely increase, lowering its relative expected returns), you will sell some of it to buy the asset class that underperformed (and now likely has higher expected returns). In that way, you’ll stay sufficiently diversified and still have a value strategy.

There’s one more important point to emphasize. While low prices relative to a value metric do predict higher returns, those higher returns are expected, not guaranteed. Lower prices are also an indicator, at least from the conventional finance point of view, that more risk present is present. In other words, higher expected returns aren’t a free lunch.

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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