Zack Shepard's blogSanity

“I want to sell a “b”illion shares.  No wait, I meant a “m”illion…whoops.”  That’s what you call a spike.  This is a snapshot of what happened to P&G stock in a matter of seconds because a trader accidentally typed a “b” instead of an “m” when submitting the trade.  Still think the market isn’t efficient?  Think again.  It washed out that news out of the stock price before anyone could react.

Building on one of my recent video posts regarding market premiums and where they come from, this post shows what the premiums are, where those premiums come from and how they are managed.

In the first image, you have three equity factors: sensitivity to the market, sensitivity to size and sensitivity to BTM (value stocks).  This image explains that there are known historical premiums for being in the market vs. fixed income, owning small companies vs. large companies and owning distressed (value) companies vs. growth companies.

In the second image, you can see that these premiums exist in the US and internationally and are very generous over long historical time periods.  One thing to keep in mind here is that with additional premium comes additional risk, therefore diversification is key so as to minimize the risk associated with these asset categories.

*In US dollars. Developed markets value and growth index data provided by Fama/French (ex utilities). The S&P data are provided by Standard & Poor’s Index Services Group. US Small Cap Index is the CRSP 6-10 Index. CRSP data provided by the Center for Research in Security Prices, University of Chicago. International Small Cap index data: 1970-June 1981, 50% UK small cap stocks provided by the London Business School and 50% Japan small cap stocks provided by Nomura Securities; July 1981-present: simulated by Dimensional from StyleResearch securities data; includes securities of MSCI EAFE Index countries, market-capitalization weighted, each country capped at 50%. MSCI data copyright MSCI 2008, all rights reserved.
Indexes are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Compound returns have an assumed rate of return, are hypothetical, and are not representative of any specific type of investment. Standard deviation is one method of measuring risk and performance, and is presented as an approximation.

In the third image, you can see two ways to manage fixed income in a portfolio.  Fixed income should be utilized in a portfolio to reduce or dampen equity risk.  Keeping maturities short and high quality is how you achieve this in a diversified portfolio.  What most people don’t realize when it comes to their investments is that as maturities lengthen in fixed income, it actually becomes as risky as stocks they hold.  Therefore, you should take the risk in equities since their expected returns are greater than fixed income.

An overall portfolio strategy utilizing these tools would beneficial to any investor, but utilizing an investor coach to implement and stay disciplined is the key to a successful investing experience.

This graphic is very interesting and telling. Let’s put this in perspective. There are currently roughly 8,400 stocks in the US market. If you exclude the Top 10% of performers each year (840 stocks this year), your return suffers 3.4% annually.

What this means is that if you go back to 1926 and invest $10,000 in all US stocks and compound annually with no additional investment, you end up with $17.3 million. If you try to pick the best performing stocks (of which there is no data supporting anyone’s ability to do so) and you miss the Top 10% of performers each year, your $10,000 investment only grows to $1.2 million. You miss out on $16 million! If you miss the Top 25% of performers each year, your return drops to -1% per year. I don’t think the math is needed for that one. Stock picking is a risky proposition. I wouldn’t try it.