Portfolio Methodology

Evidence from practicing investors and academics alike points to an undeniable conclusion: Returns come from risk. Gain is rarely accomplished without taking a chance, but not all risks carry a reliable reward. Financial science over the last fifty years has brought us to a powerful understanding of the risks that are worth taking and the risks that are not.

Everything we have learned about expected returns in the equity markets and fixed income markets can be summarized by two sets of factors. The equity market factors are as follows:

Market - stocks have higher expected returns than Fixed Income

Size - small company stocks have higher expected returns than large company stocks

Price - lower-priced "value" stocks have higher expected returns than higher-priced "growth" stocks.

While the equity markets have three factors, the fixed income markets only have two. The two factors are as follows:

Maturity - longer-term instruments are riskier than shorter-term instruments

Default - Instruments of lower credit quality are riskier than instruments of higher credit quality

The Benefits of Diversification

Successful investing means not only capturing risks that generate expected return but reducing risks that do not.  Avoidable risks include holding too few securities, betting on countries or industries, following market predictions, and speculating on "information" from rating services. To all these, diversification is the antidote. It washes away the random fortunes of individual stocks and positions your portfolio to capture the returns of broad economic forces.

For many investors, the S&P 500 represents the first equity asset class in a diversified portfolio. Although the S&P 500 Index is diversified in large US companies, investors can benefit further by adding components. Take, for example, a portfolio that holds just US stocks (S&P 500 Index), a portfolio that holds just Japanese stocks (MSCI Japan Index), and a portfolio that holds both. The diversified portfolio has not only provided higher historical return than either alone, but it has done so with fewer negative quarters.