Factor Investing: Why Your Investment Approach Should Be "Intuitive"
Updated: Dec 21, 2019
We often have conversations with potential clients about our investment philosophy and why we invest the way we do.
It’s great when we hear questions because most individual investors (and financial advisors) don’t have an investment philosophy beyond trying to get the best return. We thought all our clients might be interested in hearing a bit more detail on what guides our investment decisions.
When it comes to investing we believe it’s important to have tested principles that guide investment decisions. Specifically, we pursue factors of return that are persistent, pervasive, robust, implementable and intuitive. Prospective clients often ask what we mean by these qualifications, and we thought all our clients might be interested in hearing our answer.
First off, let’s define what we mean by a factor of return.
Academic and industry research has shown there are certain ways we can group securities with similar characteristics (i.e., factors), and then use those characteristics to find what parameters get rewarded (i.e., return). While many trusted studies support factor investing, the Booth School of Business at the University of Chicago has been instrumental in contributing to factor research. Eugene Fama also won the Nobel Prize in economics in 2013 for his research around markets and factor investing.
For example, we can group stocks into two categories based on size: In one group, we can put large market capitalization stocks (big companies), and in the other, we can put small market capitalization stocks (small companies). We can then look at how big companies have historically performed versus small companies and determine if we should invest in one group versus the other. Research has shown that small stocks outperform large stocks over the long term, and we call this the size factor of return.
To test the hypothesis that small companies should outperform large companies long-term, we can easily apply our “philosophy test” by asking if the size factor is persistent, pervasive, robust, implementable, and intuitive.
Persistence: Small stocks outperformed large over many different historical time periods
Pervasive: Small stocks historically outperformed large stocks in markets all over the world, and not just in the United States.
Robust: Small stocks historically outperformed large stocks by a meaningful amount of return over time.
Implementable: It is easy to sort stocks based on size and it doesn’t cost much to buy small stocks.
Intuitive: Small stocks are riskier than large stocks and investors should be rewarded for taking that risk.
Notice that the small company factor passes all 5 litmus tests above. As a result, we can be confident (but not guaranteed), that owning small companies in retirement portfolios may improve expected returns going forward.
Now, let’s consider a silly example of what isn’t intuitive.
There are many ways to group stocks, so let’s group them by the first letter of the company’s name. Hypothetically, let’s say we did the research and found that investing in companies that begin with the letter “A” produced the best historical return versus all the other letters in the alphabet. To make our case, we might say that Apple, Amazon and Alphabet (the parent company of Google) are all part of the strategy, and they have all performed well over the past decade.
Does investing in companies that start with the letter "A" pass our litmus test?
Persistence: Companies beginning with the letter "A" do not outperform over different time frames.
Pervasive: Companies beginning with the letter "A" do not outperform in different geographic areas across the world.
Robust: Companies beginning with the letter "A" do not produce sizable out-performance consistently over time.
Implementable: It is easy to sort stocks based on the letter "A".
Intuitive: Grouping companies based on a letter doesn’t make sense, and, therefore, isn’t intuitive. Companies that begin with the letter “A” aren’t successful (or unsuccessful) because they named their company with that letter, and letters tell us nothing about the risk we are taking.
So, how you leverage this test for your own investment portfolio?
For starters, most investment ideas you hear about on CNBC or read about in Money Magazine likely don't hold water. The next time you hear a financial expert pitching an investment idea, push back and ask him if the "strategy" passes the test above. If not, let him know you'll take a pass.
We want the bedrock of our investment philosophy to make practical sense and be supported by historical evidence. We are dealing with the life savings for many families and how those savings can help reach their life goals. We don’t want to leave client goals up to chance, a good sales story or some current trend.
If you have any questions about your investments, need to inform us of family or work-related changes or want to discuss your financial planning needs, please reach out. We are here to help you reach your financial life goals!
Mark Fonville, CFP® is a CERTIFIED FINANCIAL PLANNER™ and President of Covenant Wealth Advisors, a wealth management and fee-only financial planning firm in Williamsburg and Richmond, VA. Read Mark's bio.
Disclosures: Covenant Wealth Advisors is a registered investment advisor with offices in Richmond and Williamsburg, VA. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital.
The views and opinions expressed in this content are as of the date of the posting, are subject to change based on market and other conditions. This content contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
Please note that nothing in this content should be construed as an offer to sell or the solicitation of an offer to purchase an interest in any security or separate account. Nothing is intended to be, and you should not consider anything to be, investment, accounting, tax or legal advice. If you would like accounting, tax or legal advice, you should consult with your own accountants, or attorneys regarding your individual circumstances and needs. No advice may be rendered by Covenant Wealth Advisors unless a client service agreement is in place.
Information provided by Dimensional Fund Advisors LP and Loring Ward.
In USD. Based on monthly rolling differences in annualized returns over the periods listed. Rolling multiyear periods overlap and are not independent.
Profitability is measured as operating income before depreciation and amortization minus interest expense, scaled by book.
Indices are not available for direct investment. Index returns are not representative of actual portfolios and do not reflect costs and fees associated with an actual investment. Past performance is no guarantee of future results. Actual returns may be lower. See “Index Descriptions” in the appendix for descriptions of Dimensional and Fama/French index data. Eugene Fama and Ken French are members of the Board of Directors of the general partner of, and provide consulting services to, Dimensional Fund Advisors LP. “One-Month Treasury Bills” is the IA SBBI US 30 Day TBill TR USD, provided by Morningstar. All rights reserved. MSCI data © MSCI 2019, all rights reserved.