The role of equities in a portfolio


Equities

The role of equities within an investment portfolio is to provide the potential for the greatest expected return of all available asset classes over the long term.

By "long-term" we mean an investing lifetime of ideally 25 or 30 years. Equities can be extremely risky on a day to day basis but over the longer term this volatility tends to average out leaving investors with the overall positive return from Capitalism. We would not recommend investing in equities for terms of less than 10 years based on the experience of the last 200 years..


Source: Robert Shiller, Yale University

Equities, also known as “shares”, offer a high degree of liquidity that is to say they are readily bought and sold. They offer a higher expected return than that of other asset classes. However this higher expected return is also associated with a high degree of volatility.

We can show this volatility by looking at the distribution of returns associated with equity investment over the very long term from historical data. The following graph shows the distribution of returns of the S&P 500 in the USA over the period Jan 1926 to July 2009.


Source: Standard & Poor’s Index Services Group

Expected return

Expected return sounds predicative. In fact it is the assumed return necessary to compensate investors for the risk of buying equities and is measured by the “equity risk premium”.

The equity risk premium is the average rate of return above a risk free rate (such as a deposit account) that on average, an investor has required in order to be compensated for the risk of buying equities.

On average around the world and over the long-term, the equity risk premium has been in the order of 4%pa1. So, if a deposit account is currently offering 2%pa, on average, global equities can be expected to deliver a return of around 6%pa.

1“The Equity Premium” Eugene Fama and Kenneth French, MIT working paper, July 2000

Expected volatility

The variation in equity returns in developed markets has been, on average, around 20%pa.

We can therefore conclude that the expected distribution of returns from a diversified portfolio of global equities in developed markets to be as follows:


US Market is the CRSP Value-Weighted Index, provided by the Center for Research in Security Prices, University of Chicago.


Understanding Stockmarket investing




Traditional fund managers and stock brokers

The traditional method by which a fund manager, market commentator or stockbroker will attempt to sort equities is by sector or industry. We therefore ask the following question: 

“Can any single industry—for example, the high-tech sector or Green Energy—assure investors above-average returns?” 

Detailed research into the sources of investment returns ("Industry Costs of Equity." Journal of Financial Economics 43 (1997) concludes that industries, or companies' products, are not a factor in expected stock returns. Industry effects can influence prices, but in a seemingly random, short-term way that can be mitigated in a diversified strategy.  

Adding securities to a portfolio is only diversification if it reduces the risks that don't contribute to expected return. For example if I invest in just the banking sector, I am exposed to market risk and banking risk, by adding more sectors such as energy, pharmaceuticals etc I am diversifying banking risk until I am left with the whole market. Put differently, diversification does nothing to reduce the risks that pay off in expected return— such risks are theoretically "non-diversifiable." 

Therefore, industry effects, though they pose risks that are worth taking into account, are not a primary variable on which to sort securities for investment purposes. 

Even when looking at sectors which appear intuitively to offer good future prospects such as New Energy, firms developing new technologies have no assurance of earning above-average long-run profits. The competitive forces in a free market work constantly to disperse the benefits of innovation throughout the economy. The retailer using new high-speed computers to cut inventory costs, for example, may reap greater economic rewards than the company who developed them. If competition pressures the retailer to pass the resulting savings along in the form of lower prices, the ultimate beneficiary is the consumer.

Even if one could correctly predict technological trends, identifying the winners from an investment standpoint becomes an elusive exercise.

 As an example, consider the birth of the personal computer industry in the early 1980s and its subsequent explosive growth. Industry pioneers IBM and Apple Computer were responsible for many innovations, yet shares of both firms have lagged the broad stock market: total return for the 20-year period ending December 2001 was 333% for Apple Computer, 1360% for IBM and 1606% for the S&P 500 index (Centre for Research in Security Prices, University of Chicago; Ibbotson Associates).

Conclusion

 

The traditional approach of active fund managers and stock brokers of sorting equities based on what the company does (by sector) is not a reliable means of identifying the trade-off between risk and return and is not a suitable means of portfolio diversification.  Stock picking is speculation and gambling.

Please click on the image below to watch a video explaining the DFA advantage.