Wall Street has a wide array of mutual funds it wants to sell you. “Absolute return” this. “Midcap blend” that. “Small-cap growth” whatever.
Many brokers, advisers and salesmen will tell you that just the right mix of each one will give you a portfolio that’s “right for you,” with returns perfectly adjusted to your “risk tolerance.”
The efficient market hypothesis
Before you invest a penny, listen to Bob Haugen.
He’s a former finance professor who’s spent half a lifetime studying the stock market. He’s written a number of books and papers and is co-author of a remarkable piece of analysis titled “Case Closed.”
Haugen and co-author Nardin Baker looked in excruciating detail at the characteristics of which stocks did best (and worst) over nearly half a century, from 1963 to 2007.
Most of these “styles” are a waste of time. And the idea that you need to take on more “risk” to earn higher returns is a total con.
On the contrary, Haugen says, the stock market has a big secret. Over many decades, “the stocks with the highest risk produced the lowest returns — and stocks with the lowest risk produced the highest returns.”
In other words, he says, “the risk/return ratio was upside down . . . the payoff to risk is consistently negative over the 45-year period of this study.”
Instead of being paid to take risk, you got paid not to.
All those glamorous, sexy “growth”‘ stocks? All that extra volatility you took on in the desperate pursuit of the next big thing? It was a bad move. You would have done much better investing in the dull, low-risk, widow and orphan “value” stocks.
These winners were stocks that were cheap in relation to their net assets, earnings, cash flows and dividends. They were stocks in companies that had big and growing profits today, not pie-in-the-sky expectations for the next decade. They often also had recent positive momentum on the stock market.
While Haugen tells me it’s rare to find an individual stock that’s a “perfect fit,” you can build a portfolio of stocks that are good fits.
Investing in value works. Haugen and Baker wrote that “the evidence strongly suggests that this simple intuition is more powerful than any of the complex theories about expected return that can be found in the literature of Modern Finance!”
Value stocks actually earned you more money and gave you a smoother ride. The strategy worked even after counting trading costs.
This has not just been true in the United States, either. Haugen also looked at historical data on the British stock market. On the Paris bourse. In Germany. In Japan. The results were the same. Lower volatility stocks gave you higher returns. A free lunch.
Many professional investors already know this. But too many don’t. And many of those who do know it keep forgetting it — and rushing out and chasing expensive “growth” stocks all over again. That’s what’s been happening lately