I was at a conference hosted by Dimensional Fund Advisors last week. Dimensional believe in evidence based investing; taking their investment philosophy from the world of academia and are heavily influenced by Nobel laureate Gene Fama and his colleague Ken French.
When it comes to investing, we primarily invest in 3 different assets classes:
But what drives returns for each of these asset classes?
Markets – when you invest in a company, you get a premium for taking the risk to invest. Stocks that move more than the market are considered to be a higher risk and therefore have higher potential rewards for those who invest in them.
Company Size – Investing in companies with market capitalisation of up to $2 billion (Small Cap) have a higher level of risk than companies with market capitalisation of over $5 billions (Large Cap). As mentioned already, if you take more risk, you get greater potential rewards.
Relative Price – value premiums – This refers to the greater risk adjusted returns of value stocks over growth stocks. Value stocks are stocks that are underpriced to the market as a whole and have a higher dividend yield to the market. Growth stocks have higher growth in projected earnings and as the company performs, the share price increases to reflect this growth.
Profitability – How profitable is a company today and how profitable will it be in the future? Markets tend to underestimate future profits in today’s price, making them good value to buy now.
Term – The longer the term of the bond, the more risk you take. Why is that? Bonds have an inverse relationship with interest rates; if interest rates go up, bond prices go down. With long term bonds, there is a greater chance that rates will go up over that period. If the interest rate does go up, the longer bonds will be effected more than the short dated bonds. How? If interested rates go up by 0.25%, a short dated bond with 2 coupons left to pay will only underpay the investor by 0.25% for 2 payments. If there is 10 years left, the investor is underpaid by 0.25% for 10 payments.
Credit – You pay for the bond issuers credit rating. Not so long ago, the news was full of reports on how much Ireland had to pay in interest to issue bonds. They were seen as a bad bet and the market wanted to be compensated for the risk of default by Ireland. Germany on the other hand are seen as a safe bet and interest rates on their bonds so low that when inflation is taken into account, you make a loss.
Markets – The value of the property market is driven by what people want to pay at any point in time for that property.