Factor-Based Investing – The Equity Premium
Decades of academic research have identified that there are systematic differences in expected returns based on what is commonly referred to as factors. We can exploit these factors to structure portfolios to target higher expected returns. An example is the equity premium.
Persistent and Pervasive Factors
While there is no guarantee that these factors will continue to out-perform over time, empirical evidence has suggested that these factors have been persistent (i.e., occurred over time) and pervasive (i.e., occurred over the equity markets in various geographical regions).
4 “Premiums” of Return
Over the next several weeks, we are going to discuss the four factors that have been shown to be persistent and pervasive. These factors give rise to “premiums” of return. These premiums are:
- Equity premium
- Small cap premium
- Value premium
- Profitability premium
To be considered a dimension of expected return, a premium must be all of the following:
This week we are going to take on the equity premium. The equity premium is based on empirical evidence (i.e., data) that suggests stocks will outperform bonds.
No doubt, more than a few people reading this will be thinking “duh!” That’s OK. That the premiums are intuitive is one of the best things about them! In my opinion, the most amazing research in the world is often NOT valuable unless it is backed up by intuition—the proverbial sniff test, if you will.
The equity premium - an extra “reward”
To go into it a bit deeper, the equity premium suggests that there is an extra “reward” that is provided to those who OWN companies (i.e., stocks) versus what is provided to those who LOAN to companies (i.e., bonds).
Essentially this says that if you want to see higher expected returns in your portfolio, you need to include a higher percentage of stocks versus bonds. This approach is fundamental and well-established in building and designing portfolios.
In upcoming weeks, the other 3 premiums
In the following weeks, we will go through the small cap, value, and profitability premiums. Each of these premiums will also have a logical, easy to understand explanation that backs up what the academics have found. For this reason, I have a high degree of confidence in using a factor- based approach to investing, which is built on leveraging these premiums.
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