After 25 years of lifetime financial lessons learned, I’d like to think I’ve gotten pretty good at building and managing effective investment portfolios. I wish I could say the same for my hockey skills! Unfortunately, while I enjoy the sport immensely, I don’t think my Sunday night, three-on-three games will ever enable me or my fellow players to go pro.
Just as there’s a big difference between playing hockey versus going professional with it, there are two levels to creating and maintaining a well-balanced investment portfolio.
Believe me, you’re already skating well ahead of the pack if you can stay the course with an effective balance of stocks, bonds, real estate and cash (as described in my last post). But you can further refine your portfolio’s balancing act by taking it to a second level.
“Level Two” Portfolio Balancing
Level two portfolio balancing means not only diversifying your portfolio between major asset classes like stocks and bonds, but also managing expected levels of risk and return by more deliberately diversifying among them.
What do I mean by that? Within your stock holdings, you can tilt your portfolio slightly off center by investing more or less heavily in risk factors that are expected to reward you with higher returns over time.
This is where the evidence part of our evidence-based investment strategy becomes essential! Sometimes, empirical analysis helps us verify existing practices. Other times, it helps us dispel false assumptions and improve on those practices. To take our portfolio builds to the next level, instead of relying on guesswork or flimsy forecasting, we depend on decades of academic inquiry to help us understand which risks may be worth taking – which have actually delivered higher returns over time – and which have been just plain risky, with no resulting reward.
On Birthdays and Hockey Pros
Before we discuss the evidence on portfolio construction, let’s consider another hockey illustration. If you crunched the numbers on which young players stood the best chance at going pro, the evidence would probably verify many factors you might already take for granted, such as a kid’s interest level, parental support, physical stamina and agility, and whether he or she grew up in a country with ample opportunities to get out there and play the game. (Oh, Canada!)
But what about your child’s birthday – would that matter? You might think not. But check out this 2013 study, citing a number of previous studies, all suggesting there is a strong bias that favors kids who were born in the first rather than the fourth quarter of the year, giving them a slight age advantage over their peers. The bias existed not only in a player’s early years, but onward into the NHL, where it appeared to no longer serve anyone’s best interests.
The point is, when you shine the light of objective inquiry on a subject, you often discover better ways to approach existing challenges that prevailing assumptions have overlooked.
Understanding Investment Risk
Now, back to those market risks. By heeding the volume of academic inquiry on the subject, we have learned there are two, broadly different kinds of investment risks: avoidable, concentrated risks and unavoidable market risks.
Avoidable Concentrated Risks – Concentrated risks are the ones that wreak targeted havoc on particular stocks, bonds or sectors. Even in a bull market, one company can experience an industrial accident, causing its stock to plummet. A municipality can default on a bond even when the wider economy is thriving. A natural disaster can strike an industry or region while the rest of the world thrives.
In the science of investing, concentrated risks are considered avoidable. Bad news still happens, but you can dramatically minimize its impact on your investments by diversifying your holdings widely and globally, as we described in our last post.
Unavoidable Market Risks – If concentrated risks are like bolts of lightning, market risks are encompassing downpours in which everyone gets wet. They are the persistent risks that apply to large swaths of the market.
Academia also has revealed particular kinds of market risks that, not unlike a hockey kid’s birthday, have wielded more influence (i.e., delivered higher expected returns) than you might expect. An accumulation of studies dating back to the 1950s has identified a handful of stock market factors that you can deliberately tilt toward or away from, to achieve that second level of risk/reward balance in your portfolio:
- The equity premium – Stocks (equities) have returned more than bonds (fixed income)
- The small-cap premium – Small-company stocks have returned more than large-company stocks.
- The value premium – Value companies have returned more than growth companies. (Value stocks are the ones that, based on the empirical evidence, appear to be undervalued or more fairly valued by the market, compared with their growth stock counterparts.)
- The Profitability Factor – Highly profitable companies have delivered premium returns over low-profitability companies.
Managing Market Risks – On the Level
To recap all of the above: Every investor faces market risks that cannot be “diversified away.” If you can stay invested in riskier market factors when market risks are on the rise, you can expect to eventually be compensated for your steely resolve with higher returns. But you also face higher odds that your results may deviate from your expectations, especially in the near-term.
That’s why you want to take on as much, BUT NO MORE of this sort of market risk than is personally necessary to pursue your goals … and you want to minimize concentrated investment risks even more. By taking your portfolio management to this second level of evidence-based balance, I believe you’re best positioned to “shoot to score” when it comes to your investments.
