Investing In The Equity and Fixed Income Markets
In this episode of the Science of Economic, we focus on the basic tenets of investing in the equity and fixed income markets.
This discussion includes:
- The “first rule of successful investing,” a rule that’s almost always broken, even by most seasoned investors.
- Value stocks vs. growth stocks, and which group is the clear outperformer over multiple time periods.
- How to select the right equity mutual funds and exchange-traded funds (ETFs).
- How to use fixed income investments for capital preservation and income generation.
- Understanding credit risk and interest rate risk in fixed income investments.
- The application of science and mathematics to equity and fixed income investment selection.
Here are a few “Action Step” takeaways from this episode:
1) Determine where you are going to invest your economic freedom dollars, e.g. mutual funds or brokerage firms.
2) Research value and fixed income investing options at your chosen custodial firm.
3) Review your 401(k) or company-sponsored retirement plan to gain an understanding of the investment offerings open to you.
4) Go to www.scienceofeconomicfreedom.com and review the many articles and special reports designed to help you navigate your path to economic freedom.
Podcast Transcript Episode 7:
The time has come to start talking about investing. How should you invest your economic freedom dollars? Sit back, relax and learn about the stock and bond markets. The Science of Economic Freedom is intended as an investor education resource.
The views and opinions expressed on this program should not be construed as a recommendation to buy, sell or hold any specific security. Consult your investment advisor and read any investment prospectus carefully before making any changes to your investment portfolio.
This program is sponsored by Mercer Advisors. Mercer Global Advisors Inc. is registered with the Securities and Exchange Commission and delivers all investment related services. Mercer Advisors Inc. is the parent company of Mercer Global Advisors Inc. and is not involved with investment services. Welcome to the Science of Economic Freedom. I’m your host, Doug Fabian.
This podcast is all about helping you achieve your financial dreams. We call that economic freedom. This program is about your journey to achieve economic freedom for yourself and your loved ones. Today, we want to help you identify your next step on that journey. This is Episode 7: Start Your Growth Engine To Economic Freedom. The time has come to talk about investing. We’ve built a foundation so far on writing down our goals, building our balance sheet and understanding our spending. Now, it’s time to start our growth engines to economic freedom.
We want to grow our liquid capital. We want to ride the extraordinary wave of compounded growth. We want to achieve high rates of return balanced with the right amount of risk we are willing to take with our investable assets. This is an introduction to Mercer Advisors’ Science of Investing. Let’s play some context around the phrase science of investing. Here at Mercer Advisors, we have developed our investment strategies from 30 years of investing experience and more than 50 years of academic research. We believe in quantitative finance.
This is also known as mathematical finance. Quantitative finance is fundamentally about identifying, measuring and replicating best practices in portfolio management as precisely as possible. Mathematics is used in all scientific pursuits to ensure the highest degree of precision possible. This approach is not just Mercer Advisors but mirrors science and research with over 50 years of development. Now, we believe that successful investing is the outcome of a repeatable, disciplined and mathematical process. We don’t believe in market timing, sector rotation, stock picking or technical analysis.
With this context, let’s discuss the investment markets available for your liquid capital. Broadly speaking, there are two asset classes that offer rates of return higher than a savings account. They are the equity markets and the fixed income or bond markets. Here’s how these markets work. Businesses need capital. There are two ways to offer a business your capital. You can loan a business money and receive a fixed rate of return, then, at some predetermined point in the future, your money will be returned to you. This is how the bond market works.
The second way to provide a business your capital is to become an owner. You can buy shares in a publicly traded company. This offers you a portion of the profits with unlimited upside but your downside risk is unlimited as well and you could lose all of your money if the business failed. We’re going to focus our discussion on the stock market or equity investing first. The first rule of successful investing is diversification. We do not want to own one company, we want to own many companies. This reduces our risk of total loss significantly.
As an investor, you are in 100% control of how many companies you own. The next question becomes, which companies should I own? This is where we rely on science. There are some companies that pay higher returns than other companies. There is a score or a ratio given to some companies paying higher returns, almost like a credit score. We want to identify those companies and diversify across that group. How do we identify companies with the higher returns? We use science again. Those companies that pay higher returns are called value stocks.
Those that pay lower returns are called growth stocks. What is a value stock? A value stock is a stock that is priced lower in relationship to its dividends, earnings and cash flow than its peers. A growth stock by contrast, is a stock that may have growth potential but is providing little or no income to shareholders. For example, if the stock is trading at $10 per share and is paying a dividend of $0.50 or 5% of its value, and is compared to a stock at $10 per share paying no dividend, which do you want to own if you’re just looking at the mathematics? The stock paying the dividend.
Continuing with our theme of allowing mathematics to confirm our decision-making process, the math shows that value stocks beat growth stocks most of the time. The following statistics were compiled by Dimensional Fund Advisors. Now, let me mention our disclaimer again. Past performance is no guarantee of what may happen in the future. Using historical data from January 1928 to December of 2016, an 88-year time frame, here is the evidence. From start to finish of this 88-year period, value stocks return to 12.93% versus growth stocks of 9.33%.
This means that value outperformed growth by a factor of more than 3% per year for 88 years. That is more than a 38% increase in annual returns just by self-selecting value over growth. Now, does this mean that value beats growth every year? No, it doesn’t. When looking at one-year periods over this 88-year time frame, value beats growth 61% of the time. When looking at longer time periods, the odds increase. Overlapping 5-year periods, value outperforms growth 75% of the time. Over 10-year periods, value beats growth 85% of the time. And over 15-year periods, value beats growth 95% of the time. You can see from these examples that the longer the time period, the better the results.
This historical correlation of value over growth happens over long time periods. The value factor is an important factor to assist you in making portfolio decisions. This is not to say that value is the only factor. Here, at Mercer Advisors, we use a 5-factor model to assist clients in building their portfolios. We will discuss our 5-factor model in future episodes of The Science of Economic Freedom. One final point regarding value stocks. These companies tend to also outperform on the downside.
Historically speaking, when the stock market falls, value stocks fall less than growth stocks. Now that we have some fundamental understanding about how to start building a stock portfolio, let’s discuss the mechanics of implementation. There are 4 choices for the purchase of value stocks in your portfolio. They are mutual funds, exchange traded funds, hiring a separate account manager specializing in value stock selection or making value stock purchases yourself. We will focus on mutual funds and exchange traded funds in today’s discussion.
Both choices are comparable. They offer value-oriented funds at reasonable costs but you need to do your homework. Here are a few variables to consider when selecting a mutual fund or an ETF. First, where do I have my money invested? Are you going to open up an account at a brokerage firm or mutual fund company? If you have your assets invested at a brokerage firm, then you’ll be able to invest in either exchange traded funds or mutual funds and that brokerage firm will most likely have tools to help you select an appropriate value investment. Now, there may be a transaction fee to purchase either of these choices. You could also open up an account directly with a mutual fund company and select from their value offerings.
Now, here a few more influencing factors to consider. Do you want to use passive or active management? Passive funds are generally cheaper versus active funds that are run by a manager selecting the value stocks on your behalf. Costs do matter, so investigate the management fee, sometimes called the expense ratio of any fund you may purchase. There can also be varying types of value funds for example, small company value versus large company value or US value versus global value.
Now, this can become confusing when you’re inundated with many choices. Please try and keep this simple as you’re getting started. Now, let’s transition to a discussion about fixed income or bond markets. To review our definitions, fixed income investing at its core is a loan to a company, national government, government agency or municipality at a fixed rate for a fixed period ending with the return of your capital. There are many different types of bond investments to choose from and there are many factors to understand. The overriding consideration is quality. Quality means lower risk. Companies have credit ratings.
Those companies with lower credit ratings actually pay higher interest rates. There’s something that’s called duration. Duration is the term of the loan or the due date of the bond. Longer term durations can influence a bond’s price when current interest rates rise and fall. Mercer Advisors believes that fixed income is an important piece of any diversified portfolio.
Historically, fixed income securities, especially short term and high-quality securities, have demonstrated a low correlation to the equity markets. In our view, the primary role of fixed income is capital preservation. A secondary objective is income. Now, there are two risks associated with fixed income investing. They are credit risk and interest rate risk. Credit risk is easy to understand. The higher the quality or rating of the company or government, the lower the risk of default. By comparison, the lower the credit rating, the higher the risk of default.
Lower rated companies compensate investors for that risk with higher interest rates. Companies can and do default in the fixed income world. We compensate for that risk with a diversified portfolio of bonds. Interest rates is another factor that can influence the price of bonds or bond funds. When interest rates are rising, bond prices fall in value. When interest rates are falling, bond prices can rise in value. The shorter the duration or term of the bond, the less interest rate risk that exists. The longer the duration, the higher the risk of interest rates on that security.
Again, from an implementation perspective, purchasing a mutual fund or an ETF is much easier and more diversified than purchasing an individual fixed income security. There are thousands of mutual funds and ETFs that focus on fixed income. When choosing a fund for your portfolio, consider high quality and shorter duration. When it comes to investing, we realize that there are many choices other than equities and fixed income. For example, real estate, commodities, alternative investments. We will discuss these in future Science Of Economic Freedom podcasts.
Today, we wanted to lay the groundwork for building a portfolio for your future economic freedom. To summarize this episode, there are two primary markets to consider for your investment portfolio, the stock market and the fixed income markets. The first rule of successful investing is diversification. Academic research and historical evidence concludes that value stocks offer performance premium over growth stocks. A mutual fund or ETF is the most cost-effective way to access value stocks and fixed income investing also benefits from diversification. High quality fixed income with shorter duration has demonstrated a relatively low correlation to equities. Now, here are the action items from today’s episode.
Number one, decide where you’re going to invest your economic freedom dollars, in a mutual fund company or a brokerage company. Number two, research your value in fixed income investing options at this firm. Number three, review your 401(k) or company sponsored retirement plan. Look at it for an understanding of the investment options and see if there are any value or quality fixed income choices for you. Next up, how do you blend the stock and fixed income markets? We will learn about asset allocation and investor behavior in the next episode of The Science Of Economic Freedom.
This is Doug Fabian, thanks for listening. The Science of Economic Freedom is intended as an investor education resource. The views and opinions expressed on this program should not be construed as a recommendation to buy, sell or hold any specific security. Consult your investment advisor and read any investment prospectus carefully before making any changes to your investment portfolio.
This program is sponsored by Mercer Advisors. Mercer Global Advisors Inc. is registered with the Securities and Exchange Commission and delivers all investment related services. Mercer Advisors Inc. is the parent company of Mercer Global Advisors Inc. and is not involved with investment services.
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