How to Best Invest Your Wealth
The past few months have been challenging. The coronavirus pandemic has created historic market volatility and stocks have thus far delivered negative returns for 2020. But financial science can teach us a great deal about the best way to invest over the long term, providing an opportunity for us to feel more confident about our investing decisions. While the economy may presently be in a low-growth, volatile environment, staying the course and applying science to investing decisions will help to ensure that you can achieve your goals over time.
Making investment decisions based on science
It is perhaps one of the greatest ironies of our time that despite historic advances in many fields of scientific endeavor—climate science, finance, and medicine among them—human beings continue to rely on very non-scientific approaches to making high stakes decisions affecting their well-being. Consider the evidence: A recent survey found nearly 15% of Americans never wear a mask to protect themselves from COVID-19, despite CDC guidelines recommending they do so.1 A similar percentage of Americans also doubt climate change is real, despite near unanimity among climate scientists that industrial emissions are altering the planet’s climate.2 And Richard Thaler, a Nobel Prize winning economist from the University of Chicago, found in his research that a staggering 90% of investors think they’re above average at picking winning investments, despite the fact that it’s mathematically impossible for 90% of anything or anyone to be above average.3
Science—specifically the field of finance—can teach us a great deal about how best to invest our life savings. For nearly a century, academics have worked to bring scientific reasoning and precision to the study of financial markets; Nobel Prizes have been awarded to luminaries such as Harry Markowitz, William Sharpe, Merton Miller, and Eugene Fama, for advancing the frontiers of how we think about investing. Subsequently, investors today are better positioned than at any point in our history to make investment decisions predicated on data and economic reasoning rather than anecdotes, soundbites, or emotion.
Investing when the stakes are high
The most important decision we make as investors is to how best invest our life savings to meet our needs, achieve our dreams, and leave an enduring legacy. Whether we’re investing intergenerational wealth, retirement assets, or a child’s education fund, the stakes are high. Getting it right is of paramount importance. Should we just buy a few “hot” stocks or should we diversify globally? Should we invest in a highly ranked “active” mutual fund or a “passive” index fund? There’s no lack of books, magazines, webinars, blogs, podcasts, newsletters, TV shows, gurus, star rankings, and fund managers quick to offer advice on what we should do. Indeed, determining how best to invest can be a confusing and overwhelming decision.
There’s a perception that to beat the market one needs to be “active.” But what does this mean? In traditional Wall Street parlance, to be “active” typically refers to doing “fundamental research” to select the best stocks, sectors, or asset classes in which to invest and when. To the novice, this all sounds good. It seems logical that when we pay investment managers their fees they, in return, should be researching those investments with the highest odds of outperforming the market – and many do.
Yet year after year, most active managers routinely fail to outperform their benchmarks. For example, a 2019 study by S&P Dow Jones4, using data from the University of Chicago’s Center for Research in Security Prices, found that a staggering 97% of active managers investing in U.S. large cap stocks failed to outperform a passive benchmark over the 10-year period from 2010-2019 (see Exhibit A). These findings aren’t new; to the contrary, academics have known for many decades that traditional approaches to investing, such as stock picking, fund rankings, and market timing, all routinely failed to deliver on their promise.
Exhibit A: Percentage of Active U.S. Core Equity Funds Outperformed by Benchmarks, 2010-2019
One could conclude, based on evidence from the S&P Dow study cited above, that indexing is the best way to invest. After all, if you can’t beat indexes, why not join them? The fees are low and index-based approaches are generally tax efficient. And for many, including numerous clients, investing in a broad market portfolio—whether consisting of index funds, ETFs, or the actual underlying stocks that make up the index—is the right approach to managing their wealth. And indexing is an investment approach that, like its factor investing cousin, is grounded in the Nobel Prize-winning thinking of William Sharpe, Harry Markowitz, and many others. But believing indexing to be the final chapter in how best to invest would be the wrong conclusion to draw from the research and contributions of the many pioneering financial economists who followed in their footsteps.
At a basic level, Mercer Advisors’ factor-based investment philosophy is about defining and following a set of rules for building diversified portfolios with a high probability of delivering outperformance over time; it fundamentally seeks to incorporate the latest academic research into our portfolios and remove instinct and emotion from the decision-making process. It is based on nearly 100 years of real-world market data and academic research into factor investing.
A factor is nothing more than a quantifiable characteristic that has been shown to be a persistent (high frequency) and meaningful (high magnitude) predictor of long-term outperformance. Academic research has identified five factors that have been shown to be exactly that: stocks, value, momentum, quality, and size.
Stocks are perhaps the easiest factor to define since they represent direct ownership in a company. Being an owner means having a legal claim on the firm’s assets, including any profits or dividends. This claim is “junior” to the firm’s lenders (the bondholders) so in the event of default, stockholders get paid after bondholders—assuming there’s anything left. For assuming this risk, investors in common stock have been rewarded with what academics call an “equity premium” of about 8% annually since 1928 (see Exhibit B). The equity premium is defined as the extra return paid to stockholders over and above the returns on risk-free U.S. Treasury Bills. But investors obviously don’t earn this “premium” every year or even every 10 years. And while stocks have delivered negative returns thus far in 2020, since 1926 stocks have outperformed Treasury Bills about 70% of the time in any given year and about 85% of the time over a 10-year period (see Exhibit C).
Exhibit B: Average Annual Outperformance (Annualized)
Source: Dimensional Fund Advisors, Inc. and AQR Capital Management, LLC. Data set for stocks, value, momentum, and size is from 1928-2016; for quality is 1964-2016.
Exhibit C: Probability of Factor Outperformance Over Rolling Periods, 1926-2019
Source: Dimensional Fund Advisors, Inc. and AQR Capital Management, LLC
Value stocks make intuitive sense since most of us are value shoppers. When shopping for like products, we’d rather pay less than more. It’s not that different when it comes to investing in stocks, which we can evaluate using a variety of different “value” measures. For example, price-to-earnings is one such measure that’s simply calculated by dividing the firm’s stock price by its earnings per share (EPS), the product of which is commonly known as the “P/E ratio”. Another, more commonly used measure of value is the price-to-book ratio, which measures the firm’s stock price relative to its “book equity”, a firm’s tangible assets. Regardless of valuation methodology, firms with lower prices relative to earnings, dividends, or book equity offer investors the prospect of higher returns on their investments than firms with higher prices relative to those with similar levels of earnings, dividends, or book equity. And we see this in the historical data; while value stocks have underperformed thus far in 2020 (and indeed over the past 10 years), value stocks have outperformed more expensive stocks by an average of 5.13% annually since 1928 (see Exhibit B).
Momentum is the observation that objects in motion tend to stay in motion. And humans, if anything, are herd animals; investors love a good story and are apt to chase and fuel trends in hot asset classes. We see this phenomenon manifest itself in asset prices all the time in markets. In the 1600s, it was the market for Dutch tulips. In more recent times we’ve observed momentum in everything from real estate and dot-com stocks to oil and technology companies. In an investment context, momentum is most commonly measured by a stock’s trailing 12-month price change relative to the price changes of other stocks within the same asset class. And investing in momentum stocks has proven to be quite lucrative, with high momentum stocks outperforming low momentum stocks just over 6% annually since 1928; they’ve also outperformed the market as a whole thus far in 2020 (Exhibit B).
Quality can be measured in several different ways. Some measure quality using return on equity (ROE) while others will incorporate additional measures such as debt-to-equity. Still others measure quality using operating profitability relative to price. Quality, at a high level, ultimately seeks to measure the “quality” of the firm’s profitability relative to the price of the firm’s stock. And this approach has delivered for investors – high-quality stocks have outperformed low-quality stocks by nearly 4% annually since 1964 and have continued to outperform again thus far in 2020 (Exhibit B).
The size of a company is another factor that has been shown to deliver outperformance over time, specifically outperformance of smaller relative to larger companies. A company’s size is measured by its capitalization. Capitalization is simply calculated by multiplying the firm’s stock price by the total number of shares outstanding. Smaller companies typically face greater risks than their larger counterparts; they typically have more limited access to investor capital, smaller or more tenuous market share, and face barriers to scaling their businesses. Subsequently, investors earn a higher premium on small company stocks over time for bearing these risks. And while small company stocks have underperformed large company stocks thus far in 2020, small company stocks have outperformed large company stocks by over 4% annually since 1928 (Exhibit B).
Achieving better outcomes over time
While science offers few guarantees, investors should be mindful that factors outperform over time, not every time. No investment approach delivers market-beating returns all the time. Subsequently, to benefit from factor investing—indeed any investment strategy—investors need to stay the course through good markets and bad. And while financial science offers no guarantees, it has successfully identified those approaches that, when consistently applied, have reliably outperformed other, non-scientific approaches to investing.
1 Wear a Mask in Public? USA Today, May 21,2020, https://www.usatoday.com/story/news/politics/2020/05/21/coronavirus-wearing-mask-public-common-nationscape-survey-finds/5215365002/
2 U.S. is Hotbed of Climate Change Denial, The Guardian, May 8, 2019, https://www.theguardian.com/environment/2019/may/07/us-hotbed-climate-change-denial-international-poll
3 Thaler, Richard H. and Sunstein, Cass R. Nudge: Improving Decisions About Health, Wealth, and Happiness. Page 32.
4 S&P Dow, “SPIVA US Year-End 2019 Scorecard: Active Funds Continue to Lag”; https://www.spglobal.com/en/research-insights/articles/spiva-u-s-year-end-2019-scorecard-active-funds-continued-to-lag
Mercer Advisors Capital Markets Update and Outlook: October 2020
Oct 21, 2020
Managing a Financial Windfall With SRI
Oct 21, 2020
How to Invest for Social and Environmental Impact
Sep 23, 2020
ESG Investments Join the Mainstream
Sep 10, 2020
Equity Compensation Part 3: Managing Concentrated Stock Risk
Aug 10, 2020