Not So Easy

Adam M. Grossman

I RECENTLY CAME across an academic paper with an attention-grabbing title: “It has been very easy to beat the S&P 500.” Not just easy, but very easy. 

That got my attention because, in recent years, beating the S&P 500 has been anything but easy. In fact, it’s been maddeningly difficult. In eight of the past 10 years, domestic markets have outperformed international markets—by a wide margin. A dollar invested 10 years ago in the S&P 500 would be worth $4.37 today. But if you had invested that same dollar in overseas markets, it would be worth barely half that.

So if there’s a simple formula to do even better than the S&P 500, what is it?

It turns out that this academic paper doesn’t break any new ground, but it does serve as a useful reminder that the investment world’s obsessive focus on the S&P 500 is somewhat arbitrary. Just as stocks and bonds have performed very differently, so too have different kinds of stocks. While there is no guarantee that the future will mirror the past, there is indeed a formula that’s demonstrated success over many years.

In fact, this formula has been understood since 1992, when two finance professors, Eugene Fama and Kenneth French, published a study on what’s now known as the “Fama-French three-factor model.” Their insight was both simple and profound. They found that just three factors explained a large part of the performance of stocks:

The first factor is the return of the overall market. When the broad market is rising, most individual stocks rise along with it. And when the overall market is falling, most individual stocks fall as well. They don’t all move up and down in perfect lockstep. But in general, stocks tend to rise and fall together.

The second factor is the size of the company. Specifically, stocks of small companies tend to outperform those of big companies. If you think about it, this makes logical sense.

Consider a company like Apple, with $250 billion in revenue. How likely is it that Apple could double in size from here? It’s possible, but hard to imagine—and it would certainly take a long time. Now consider a smaller company, one with $250 million in revenue, instead of $250 billion. How likely is it that this smaller company could double in size? It’s not guaranteed, of course, but it’s much easier to imagine. That’s the nature of smaller companies. On a percentage basis, it’s far easier for them to grow.

The third factor is valuation. In simple terms, highflying stocks don’t fly high forever. Eventually, they lose steam, fall behind and actually underperform over the long term.

Why does this happen? Wall Street and the media tend to focus on innovative, exciting companies—think Netflix, Tesla and Under Armour—and don’t give nearly as much attention to older, more mature companies, whose stories aren’t as exciting. The result of all that attention is that it can drive up the share prices of popular companies to unwarranted levels. This sets them up for a fall—and, when highflying stocks fall, they fall hard. Meanwhile, the more mature, more boring companies just keep doing what they’re doing, which is to generate reliable profits, leading their stocks slowly but steadily higher. And that’s why, on average and over time, boring companies with modest valuations tend to outperform exciting companies with much richer prices.

That, in short, is the formula discussed in the academic paper. And while I would never call any type of investing “very easy,” it has worked historically.

Since Fama and French’s original work appeared in 1992, academics have uncovered additional factors that correlate with higher stock returns. These include companies with higher profitability, upward stock price momentum and low share price volatility.

This raises a question: Should you fill your portfolio with investments tied to one or more of these factors? My answer is “yes, but.” Fama and French’s original paper offered simple but valuable insight. If, however, you build a portfolio that includes too many factors, you run the risk of creating an unpredictable stew. Maybe all these factors will work together in harmony. But they’re just as likely to offset each other and perhaps compound losses when the market declines. That’s why I have a simple recommendation: If you’re looking to build a portfolio, start with a total-market approach, then add only Fama and French’s two original factors, small-cap and value, and nothing else.

Is that recipe going to make it “very easy” to outperform? As I said, nothing is easy. Indeed, tilting toward value has hurt performance in recent years. But I do think it stacks the odds in your favor—over the long term.

Adam M. Grossman’s previous articles include Many Happy ReturnsOracle of Boston and When in Doubt. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.

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