By Mark F. Toledo, CFA
Can blindfolded monkeys throwing darts at pages of stock listings to select portfolios that will do just as well, if not better, than both the market and the average portfolio constructed by professional money managers?
The Dart Board
Exhibit 1: US Stocks Sized by Market Capitalization
Exhibit 1 shows the components of the Russell 3000 Index (a proxy for the US stock market) as of December 31, 2016. Each box represents a stock in the index. The size of each box signifies the stock’s market capitalization weight in the index.
For example, the largest box represents the largest company - Apple (AAPL). The boxes get smaller as you move from the largest cap stocks at the top to small caps at the bottom. The colors differentiate equity market segments- large cap value stocks (LV), large cap growth stocks (LG), small cap value stocks (SV), and small cap growth stocks (SG).*
This exhibit also represents a proxy for the aggregate portfolio for all investors. For every investor choosing to “overweight” a stock relative to its market cap weighting in the index, another investor must “underweight” that same stock. Therefore, the aggregate portfolio for all investors looks like the overall market.**
Exhibit 2. US Stocks Sized Equally
Exhibit 2, on the other hand, represents the dart board the monkeys use to play their game. Here, the boxes represent the same stocks shown in Exhibit 1, but instead of weighting each company by market cap, the companies are weighted equally.
For example, in this case, Apple’s box is the same size as every other company in the index regardless of its market cap. If one were to pin up pages of newspaper stock listings as a dart board, Exhibit 2 would be much more representative of what the target would look like.
Different Dart Boards, Different Results
When looking at Exhibits 1 and 2, the significant differences between the two are clear. In Exhibit 1, the surface area is dominated by large value and large growth (blue and green) stocks. In Exhibit 2, however, small cap value stocks dominate (gray).
Why does this matter? Research has shown that, historically over time, small company stocks have had excess returns relative to large company stocks. Research has also shown that, historically over time, value (or low relative price) stocks have had excess returns relative to growth (or high relative price) stocks. Because Exhibit 2 has a greater proportion of its surface area dedicated to small cap value stocks, it is more likely that a portfolio of stocks selected at random by throwing darts would end up being tilted towards stocks which research has shown to have had higher returns when compared to the market.
This does not mean, however, that haphazardly selecting stocks by the toss of a dart is an efficient or reliable way to invest. For one thing, it ignores the complexities that arise in competitive markets.
Consider, as an example, something seemingly as straightforward as a strategy that holds every stock in the Russell 3000 Index at an equal weight (the equivalent of buying the whole dart board in Exhibit 2). To maintain an equal weight in all 3,000 securities, an investor would need to rebalance frequently, buying shares of companies that have gone down in price and selling shares that have gone up. Price changes drive these transactions by altering each individual holding’s respective weight in the portfolio. By not considering whether or not these frequent trades add value over and above the costs they generate, investors are opening themselves up to a potentially less than desirable outcome.
Instead, a systematic and purposeful approach that takes into consideration factors that explain differences in expected returns across stocks and real-world constraints could increase your chances for investment success. Considerations for such an approach include: understanding the drivers of returns and how to best design a portfolio to capture them, determining a sufficient level of diversification, how to appropriately rebalance, and last but not least, how to manage the costs associated with pursuing such a strategy.
The Long Game
Finally, the importance of having an asset allocation well suited for your objectives and risk tolerance, as well as being able to remain focused on the long term, cannot be overemphasized. Even well-constructed portfolios pursuing higher expected returns will have periods of disappointing results. We can help you decide on an appropriate asset allocation, stay the course during periods of disappointing results, and carefully weigh the considerations mentioned above to help you decide if a given investment strategy is the right one for you.
So what insights can investors glean from this analysis? First, by tilting a portfolio towards sources of higher expected returns, investors can potentially outperform the market without needing to outguess market prices. Second, implementation and patience are paramount. If one is going to pursue higher expected returns, it is important to do so in a cost-effective manner and to stay focused on the long term.
*Large cap is defined as the top 90% of market cap (small cap is the bottom 10%), while value is defined as the 50% of market cap of the lowest relative price stocks (growth is the 50% of market cap of the highest relative price stocks). The determinations of Large Value, Large Growth, Small Value, and Small Growth do not represent any determinations Dimensional Fund Advisors may make in assessing any of the securities shown.
**For more on this concept, please see “The Arithmetic of Active Management” by William Sharpe.
Past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Chicago Partners Wealth Advisors(“CP”)), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profi table, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from CP. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. CP is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. A copy of the CP’s current written disclosure statement discussing our advisory services and fees is available upon request. If you are a CP client, please remember to contact CP, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services
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