From: Tad Borek
Newsgroups: misc.invest.financial-plan
Subject: Re: understanding risk
Date: 15 Jun 2005 17:00:02 GMT
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Elle wrote:
>>FWIW, most of the long-term portfolio recommendations I've made since
>>1999 included a REIT allocation. I usually lean towards value stocks
>>much more than in the allocation I ran, and of course the past five
>>years has been a great period for value. Value stocks are riskier,
>>though, and I wouldn't represent their recent perfomance as typical,
>
> This is not science. Assertions like the above should, I feel, be qualified
> as being a hunch as much as anything well-reasoned.
Elle, what may be a hunch for you is well-reasoned for me - if you're
talking about the decision to overweight value stocks within a
well-diversified portfolio (don't forget that the starting point is
that: hold a well-diversified portfolio including a variety of asset
classes). If it sounds like a hunch, perhaps you haven't read up on the
growth vs. value issue as part of an inquiry into "understanding risk."
It's pivotal to this whole question really.
In a nutshell, the idea is that the value side of the market, as defined
by book to market value (or perhaps P/E), has historically produced the
highest returns, meaning higher than growth stocks or the broad market
itself. It was originally observed in the US market, then confirmed in
overseas markets by a number of different studies.
There are a few competing theories on why these returns might crop up,
mostly centered on risk - meaning, value stocks as a group are riskier,
hence should have higher expected returns. A problem with his is that
value as a group has tended to be less volatile, so it suggests there's
more to risk than how squiggly the price line is.
My take on it - as a contrarian, when it comes to investing - is that a
large contributing factor is that value stocks tend to be the ones not
being touted on Wall Street. By weighting towards value you're more
likely to avoid the garbage of the market and, by extension, avoid the
worst parts of the asset bubbles (regardless of the industry sector they
occur in).
Regardless, if value equates to risk, one way to increase the riskiness
of a portfolio would be to increase the allocation to value stocks.
You can call that a hunch and do something different, but it should be
based on a critique of the theory describing the "value premium." The
seminal paper on this was authored by Eugene Fama & Kenneth French, it's
called "The Cross-Section of Expected Stock Returns" (Journal of
Finance, 1992). Here's a quick overview of the topic from Efficient
Frontier:
http://www.efficientfrontier.com/ef/999/risk.htm
Here's a much more detailed analysis with discussion of how to approach
an overall asset allocation. You may find espcially interesting the
breakdown of the S&P 500 into size and value components partway down the
page, you can see how it's so heavily weighed large-growth. This is part
of the argument for adding value to an account like Anoop's (he said
he's S&P500 + MSCI-EAFE), and is somewhat revealing vis a vis using the
S&P 500 as proxy for the US market:
http://library.dfaus.com/articles/dimensions_stock_returns_2002/
I agree that this isn't hard science but we are well beyond mere
hunches. Arguably the only hunch aspect of this is whether an effect
that's persisted for many years in many markets is going away. It could,
but I have a hunch it won't. Based on your cynical comments regarding
brokerage firms, product distribution and investor behavior (which I
largely agree with, BTW) you might conclude - as I have - that the value
premium isn't likely to go away until human nature changes radically and
permanently.
-Tad
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