How Much Tilt? What Kind of Tilt?
July 29, 2014
by William Bernstein
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The following is excerpted from William Bernstein’s recently published book, Rational Expectations: Asset Allocation for Investing Adults (Investing for Adults), which is available from the link accompanying this article.
In Chapter 1, I discussed how small and value stocks had higher expected returns than the broad market, and later on we’ll see how aggressive periodic investing early in the life-cycle is much less risky than it looks. That doesn’t mean, however, that the lack of risk tolerance in younger investors won’t derail the majority of them.
The first question is whether tilting towards small and value stocks still carries a premium. The answer, I think, is yes; the premium for small stocks is a classic example of Ilmanen Risk: bad returns in bad times, which certainly showed up in the two great panics of the last century: the 1929–1932 and 2008–2009 bear markets. Ditto for value exposure, plus the behavioral attraction of investors towards growth stocks, also discussed in Chapter 1.
Some worry that now that large institutional funds – particularly hedge funds and ETFs – are chasing these factors, these premiums will erode, or completely disappear. This may now be true in normal times, but in bad states of the world, in the words of Billy Ray Valentine in Trading Places, the suckers get cleared out: not just naïve small investors but also hedge funds, who will be forced to unload their positions as their clients pull out and as their liquidity – that is, their sources of leverage – dries up faster than a rain gully in the desert. This will likely produce, as happened in 2008–2009, a sharp contraction in prices that will remind investors of the risk of the value and small premiums, and so set the stage for subsequent higher returns.
Theoretically, the young saver should tilt her portfolio heavily towards small value stocks. In Ages of the Investor I examined the process of dollar cost averaging, as a young saver might, into the S&P 500 and Fama-French small value series over a series of rolling 30-year periods. The value premium, for example, is quite fickle. Since 1926, it has yielded negative returns for as long as 15 years. The small premium is even worse, yielding negative returns for as long as 30 years.
This occasional long-lasting underperformance of both the small and value factors, though, is of more concern to lump-sum investments than to a stream of periodic investments, because the ability to occasionally purchase small and value stocks at a low price mitigates any temporary underperformance of small and value stocks.
In Ages of the Investor, I analyzed the tilt towards small and value with the following paradigm. I began with the inflation-adjusted return for the longest data series we have for small-value stocks – the Fama-French small-value index, with utilities included, between July 1926 and October 2011. This index returned 10.50% real-annualized, which was 3.88% per year more than the 6.62% real-annualized return for the S&P 500.
Now imagine that a real $100 per month (in 1926 dollars) was invested for 30 years – 360 monthly purchases – for all of the starting dates between July 1926 and November 1981. In each and every case, the small-value strategy beats investing in the S&P 500 – sometimes by a huge margin.
But the 3.88% annualized return advantage of small value stocks during this period is unrealistic, as already discussed. Figure 2-7 shows that when the returns of small value stocks and the S&P were equalized at 6.62% by adjusting the monthly returns down by a constant amount, the small value strategy still won 71% of the time, because the greater volatility of small stocks allowed for a greater number of shares to be bought at lower prices.
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