A pragmatic framework, rooted in decades of data.
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Many prospective clients often ask, “what can we do to beat the market?” Before they met us, most of them were only focused on getting the best investment returns.
I like to analogize this to going on a vacation: would you pick your transportation (car, train, plane, or bus) before you knew where you wanted to go on vacation? Similarly, we often try to build our portfolio before we know how much money we’ll need for our goals - sounds backwards right?
If you know you’ll need $1 million by the time you’re 40 to do everything you love, why would you take on more risk than you need in order to get there?
Initial consideration:
As a fiduciary, it’s my responsibility to work backwards from your goals, because when it comes to investing, there’s no free lunch. The higher the returns you chase, the more risk and/or volatility you take on.
If you chase the higher return (e.g. $2 million by 40), you proportionally increase your risk of not even meeting your initial target on time (e.g. $1 million by 40) because we’d need to invest in increasingly riskier assets to get you there.
Let’s switch gears:
Now, let’s say you actually need better-than-market returns to get to your financial goals, and you have the risk capacity and willingness to try.
There’s a few schools of thought when investors try to “beat the market.” Let’s check out one of the most evidence-backed ones here - using small-cap stocks to boost returns.
For those who are new, beating the market just means outperforming a benchmark you match yourself up against - usually over a long period of time because monthly, quarterly, and even annual check-ins can be volatile and misrepresentative of your portfolio’s return potential.
Not all stocks have the same expected returns, because they have different characteristics (their growth, future plans, and profitability, just to name a few). However, academic research by multiple esteemed Nobel Prize winners and PhDs, including Eugene Fama and Ken French, indicates there’s a reliable metric that we can use to determine how a stock will perform: company size.
Small-Cap Exposure:
Company size tends to have a significant impact on returns - as you’ll see from the chart below (prefacing this with: past performance is not indicative of future results). The small-cap index has outperformed the large-cap index over the long-term. The concept is simple: smaller companies have a much higher ceiling for growth compared to larger companies. However, this also comes at a greater risk because smaller companies also have a higher chance of failure than larger companies. So, this is not an endorsement to blindly invest in a small-cap index ETF (which invests in all types of small companies - good and bad). The idea is to find smaller companies with: a strong balance sheet, consistent profitability, and high growth potential because they are underpriced (also known also ‘value’ companies). If you find these companies, your portfolio should benefit from higher expected returns without taking on a symmetric amount of risk.
Source: Dimensional Research
Remember, American small-cap equities might not do as well in the short-term and could be more unpredictable than only having large-cap equities. But we base our methods on solid, proven research when we invest. Just like science and engineering, it's essential to base your portfolio on advanced, thorough research.