"An investment in knowledge pays the best interest
- Benjamin Franklin
No one likes to see the value in a portfolio go down. For most clients the funds Pillar manages represent the tangible by-product of a lifetime of effort to live on less than they made and create future financial security for themselves and those they love. "Important" does not begin to convey how much this money means...
Which is why understanding (not just intellectually but also emotionally) what you own and what you should expect from what you own is critical. Here's a Q&A on what your "Evidence Based" expectation for the future should be:
Q#1:
The word "stock" or "equities" or "mutual fund" are words thrown around a lot but what do those words mean?
A:
These are just euphemisms for owning companies. If you're diversified you could own thousands of companies! The property, plant and equipment as well as intellectual property and productive capacity of the people who work there. Oh, and the profits too - you're an owner!
Q#2:
What should I expect to get as a "return" for owning these companies?
A:
On average over the last almost 90 years you can expect to earn 8% more than owning bonds but it varies widely year to year!
Q#3:
Do we know in advance what kind of companies will do best in a given year?
A:
No. Although there is no shortage of those who tell you they know - they don't. No one has a crystal ball or they'd only own that company and nothing else...
Q#4:
So, since you don't know what will do best in given year how do you choose which companies to own?
A:
We don't know the exact companies will produce the best returns BUT we do know what attributes of companies (we call these "Risk Factors") have higher expected returns.
Q#5:
What are those "Risk Factors" which produce higher returns?
A:
Excellent question (glad I asked it)! The risk factors are these: 1) Small companies outperform large, 2) Value (inexpensive) companies outperform growth and 3) companies with higher profitability outperform those with lower.
Q#6:
How much more expected return should I expect for owning companies with each "Risk Factor"?
A:
Small company advantage = 3.62% per year Value advantage = 5.1% per year Profitability advantage = 3.08% per year
Q#7:
That sounds awesome! I'll outperform the markets every year?
A:
No. Risk Factors don't produce extra returns every year. For example it has been significantly better to own growth than value over the last ten years! However, Risk Factors do affect your "expected" return - when you own a portfolio weighting Risk Factors you can expect higher returns over time from your portfolio - just not every year!
Q#8:
Why own bonds if they produce lower returns?
A:
Bonds have a lower expected return. Because they are much less volatile they provide a ballast against market declines for clients who may not have the time or stomach for the large fluctuations which occur when you own companies (read: stocks).
Q#9:
Why Diversify?
A:
Diversification can be across lots of companies but also by owning across geographies. International and Emerging Markets increase diversification and lower risk without reducing expected returns. IE: it's our only free lunch as investors.
Q#10:
What do you recommend investors do when markets go down?
A:
Its worthless to worry about things we cannot control. If you have done a thorough risk-assessment with your advisor - then don't worry. You have already evaluated this scenario and agreed you can handle it. Relax in the knowledge that this was part of your planning...
Want to know more about Risk Factors?
Check out the following PowerPoint presentation on the history of the magnitude and frequency of Risk Factors producing excess returns in markets around the world. Also a brief discussion of how markets tend to perform after a decline...
Risk Factors
