A prudent investor is an investor that challenges what is normal in the investing world in which we currently live. Unlike the prudent investor, the average investor lets emotion get the best of him or herself and this can cause returns to be catastrophically low over time (which typically results in this investor not being adequately prepared for retirement). Prudent investors take a more scientific approach which is based in fact and logic. The facts of the markets are described below and, if you choose to be a prudent investor, you can use these to your advantage.
Academic research has shown that 96% of equity returns can be explained by three equity risk factors1. Notice the three factors do not include stock picking and market timing. Stock picking and market timing are often the result of emotional investing which, as described above, can result in extremely low individual portfolio returns. The good news is that you don't need to be a stock picker or market timer to do well in the markets. The academic research has also identified two fixed income factors2.
The three equity risk factors are:
- Market—stocks have higher expected returns than fixed income securities.
- Size—small cap stocks have higher expected returns than large cap stocks.
- Book-to-Market (BtM) or Style—lower-priced “value” (high BtM) stocks have higher expected returns than higher-priced “growth” stocks (low BtM).
From 1927-2011 being in the total market has returned 7.94% more than T-Bills, Small Stocks have outperformed Large Stocks by 3.66%, and Value Stocks have outperformed Growth Stocks by 4.73%.
Two additional factors reflect compensated risk in the fixed income markets. These are:
- Term/Maturity—longer-term bonds are riskier than shorter-term instruments.
- Credit—instruments of lower credit quality are riskier than instruments of higher credit quality.
Term/Maturity factor for 1927–2011, it was an annual arithmetic average of 2.51%. Data series used are:
a. 1927–present: Ibbotson Long-Term Government Bonds minus Ibbotson One-Month US Treasury Bills.
The credit factor for 1927–2011 as an annual arithmetic average of 0.63%, composed of the following data series:
a. 1927–1972: Ibbotson Long-Term Corporate Bonds minus Ibbotson Long-Term Government Bonds;
b. 1973–present: Barclays Capital US Long Credit Baa Index minus Barclays Capital Long US Government Bond Index.
Equities have offered a higher expected return than fixed income, but these stronger premiums come with higher risk. Fixed Income dampens the volatility in the portfolio. Unless you are a “Risk Taker” , we need both offense (Equities) and defense (Fixed Income) in a diversified portfolio.
Structuring a portfolio around compensated risk factors can change many aspects of the investment process. Rather than focusing on individual stock or bond selection, investors work to achieve diversified, controlled exposure to the risk factors that drive expected returns.
A prudent investor first determines his or her portfolio’s equity or stock/bond or fixed income mix, and then decides how much additional small cap and value to hold in pursuit of higher expected returns. The level of risk assumed in the fixed income component may depend on why an investor is holding fixed income. For example, an equity-driven investor who wants to reduce portfolio volatility may hold less risky debt instruments, while an investor pursuing higher yield or income may take more maturity and default risk.
You should only take the risk you need to achieve your objective, not all the risk you can stomach. Let us help you design your optimal prudent portfolio.
Source: Dimensional Fund Advisors study (2002) of 44 institutional equity pension plans with $452 billion total assets.
Factor analysis run over various time periods, averaging nine years. Total assets based on total plan dollar amounts as of year end 2001.
Average explanatory power (R2) is for the Fama/French equity benchmark universe.
Equity factors provided by Fama/French. Maturity factor and credit factor data (1927–1972) provided by © Stocks, Bonds, Bills, and Inflation Yearbook©, Ibbotson Associates, Chicago (annually updated work by Roger G. Ibbotson and Rex A. Sinquefield). Credit factor data (1973–present) provided by Barclays Bank PLC. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio.