The holy grail of investing is the search for investment strategies that can deliver higher expected returns without increased risk, or the same expected return with reduced risk.
In our 2014 book, “Reducing the Risk of Black Swans,” my co-author Kevin Grogan and I showed how, for 20 years, our firm, Buckingham Strategic Wealth, has been using what we refer to as the science of investing (evidence from peer-reviewed academic journals) to help investors build more efficient portfolios—portfolios that not only have delivered higher risk-adjusted returns, but have significantly reduced the negative impact of rare events known as “black swans.”
The “secret sauce” was adding exposure to factors (such as size and value) that provided a unique/independent source of excess return. In addition, these factors should be persistent across long periods of time, pervasive across the globe and asset classes, robust to various definitions, implementable (meaning they survive transaction costs), and have logical risk- or behavioral-based explanations for why we should expect the premium to continue.
By adding exposure to factors that not only provide higher expected returns but also uncorrelated returns, investors can lower their portfolio’s exposure to market beta and increase their exposure to safe bonds.
In other words, they can lower their allocation to equities because the equities they hold have higher expected returns. As the following example shows, the result has been, at least historically, more efficient portfolios.
35 Years Of Data
Due to data limitations, we’ll examine the 35-year period from 1982 through 2016. We will look at two portfolios, A and B. Portfolio A has a typical allocation of 60% S&P 500 Index/40% five-year Treasury notes. Portfolio B will hold 25% stocks and 75% five-year Treasury notes.
With U.S. stocks representing roughly half of the global equity market capitalization, we will split the equity allocation equally between U.S. small value stocks (using the Fama-French U.S. Small Value Index) and international small value stocks (using the Dimensional International Small Cap Value Index).
As you can see, while Portfolio A produced an annualized return 0.6 percentage points higher than Portfolio B (10.3% versus 9.7%), it did so while experiencing volatility 3.1 percentage points greater (10.3% versus 7.2%). In relative terms, Portfolio A’s annualized return was only 6% greater than Portfolio B’s, while the volatility it experienced was 43% greater.
In addition, Portfolio B had fewer events in the “tails” of the return distribution (said another way, it had both fewer extremely good and fewer extremely bad return years). While Portfolio A had 11 years with returns greater than 15%, Portfolio B had nine. And while Portfolio A had just a single year with a loss of greater than 15%, Portfolio B never experienced a loss that large.
Moving the hurdle to years with 20% gains/losses, we see that Portfolio A had seven years with returns greater than that level, and no years with losses of that size, while Portfolio B had just two years of gains that large. Moving the hurdle to the 25% level, both Portfolio A and Portfolio B had two years with returns in excess of that amount and no years with losses that great.
The best single year for Portfolio A was 1995, when it returned 29.3%. The best single year for Portfolio B was 1985, when it returned 28.0%. Note that while Portfolio B has just 25% in equities, its best year was almost as good as the best year for Portfolio A, which has 60% in equities. On the other hand, Portfolio A’s worst single year was 2008, when it lost 17.0%. The worst single year for Portfolio B was 1994, when it lost just 1.2%.
What’s more, while Portfolio A experienced five years of negative returns, Portfolio B experienced just three. Portfolio B was not only the more efficient portfolio, it offered much greater downside protection. Thus, Portfolio B should be greatly preferred by risk-averse investors, especially those in the withdrawal phase of their investment careers, when the order of returns increases in importance.