One question all equity investors must answer is how to allocate their investments within the wide-ranging equity market. Should they try to pick individual stocks to outperform the market or invest in mutual funds? Should they invest in domestic companies or international ones? There are a handful of investment premiums that can help investors to answer these questions. These premiums are at the core of designing a portfolio to achieve your goals.
Equity Risk Premium
If you have ever heard that stocks outperform bonds over the long term, then you are familiar with the equity risk premium. This premium simply states that equities are expected to provide excess returns to investors to compensate for the larger risk taken on compared to investors in low-risk asset classes such as government bonds. This instinctively makes sense: if high-risk and low-risk investments had the same expected return, no one would invest in the higher risk assets. The equity risk premium recognizes the fact that many equity investments will fail as companies go bankrupt or underperform, with the larger potential for growth working as an incentive for investment.
The size premium is the tendency for investments in smaller companies to outperform those in larger companies. This premium was popularized in 1992 by Nobel laureates Eugene Fama and Kenneth French, and has been a staple of many equity investment approaches ever since. Once again it demonstrates a compensation for investments in riskier small companies compared to established large companies. The graph below shows the historical 10-year premiums of small cap minus large cap returns, the blue bars showing 10-year periods of small cap outperformance.
Another premium discovered by French and Fama is the value or price premium. This premium is the tendency of value stocks (companies whose stock has a lower price-to-book value than similar companies) to outperform growth stocks (companies with relatively high price-to-book value) over time. Once again, history leans to the side of value outperforming growth, thus giving value investors a premium over the overall market.
The newest discovered investment premium is the profitability premium. It explains that companies that are highly profitable tend to outperform firms that have low profitability over time. Stock returns are all about future expectations, and French and Fama have found that a firm’s current profitability contains information about its future profitability, explaining why companies that are profitable now tend to outperform in the future.
All four of these premiums can be important on their own, but investors normally get the most promising results by using a combination of these premiums. Like always, individual goals and risk tolerance need to be assessed before deciding the most appropriate investment strategy. To hear more about how we can utilize premiums to help you achieve your financial goals, visit our website www.kdminvest.com.