Investment Philosophy
Overview
At Five Factor Capital Advisors, we see markets as an ally, not an adversary. Rather than try to take advantage of the ways markets are mistaken, we take advantage of the ways markets are right.
We offer a disciplined, unemotional, and highly diversified investment approach that offers objective advice and solutions to problems, rather than financial products to buy.
Our investment approach, Five Factor Investing, is based on the science of capital markets, not on costly speculation. This approach focuses on what really drives investment return, helps reduce volatility, and simplifies the investment process. The core concepts are not new, they are time-tested and supported by decades of academic research.
Markets Work
Markets throughout the world have a history of rewarding investors for the capital they supply. Companies compete with each other for investment capital, and millions of investors compete with each other to find the most attractive returns. This competition quickly drives prices to a fair value, ensuring no investor can expect greater returns without bearing greater risk.
Traditional investment managers strive to beat the market by taking advantage of pricing "mistakes" and attempting to predict the future. This often proves costly and futile.
Prices for public securities are fair and persistent differences in average portfolio returns are explained by differences in average risk. It is certainly possible to outperform the markets, but not without accepting increased risk.
When you reject costly speculation and guesswork, investing becomes a matter of deciding how much to allocate across five factors: (1)stocks vs. bonds, (2)small cap vs. large cap, and (3)value vs. growth in markets around the world - and how much (4)term and (5)credit exposure to target in fixed income. A 1986 Study by Brinson, Hood and Beebower, identified that by far the greatest determination of investment performance was not market timing and stock picking but the allocation among these Five Factors.
Diversification is Essential
Capital markets are composed of many types of securities, including stocks, bonds and cash, both domestic and international.
A group of securities with shared economic traits is commonly referred to as an asset class. Landmark research done by Nobel Prize winning economist, Harry Markowitz, shows that diversification across all asset classes as well as within each of those asset classes reduces risk. Because the asset classes play a different role in a portfolio, the whole is often greater than the sum of the parts. As a result, investors have the opportunity to achieve greater expected returns over time with lower volatility that they would in a less diversified portfolio.
Five Factors Explain Performance
The Five Factor Capital Advisors investment model is based on the principles of Modern Portfolio Theory espoused by two leading academics in the world of finance, Eugene Fama and Ken French.
Decades of historical performance and the academic study of capital markets have led to the undeniable conclusion that investment returns are directly related to risk, and not all risk is created equal. Rigorous peer reviewed studies, market observations and time tested theories have yielded an investment science that can evaluate which risks are worth taking and which are not.
There are five factors of measureable risk:
There are five factors of measureable risk:
(Stock Factors)
(Fixed Income Factors)
Stocks have higher risk and higher expected returns than bonds.
Small company stocks have higher risk and higher expected returns than large company stocks.
Value stocks have higher risk and higher expected returns than growth stocks.
Long term bonds are subject to the risk of unexpected changes in interest rates and therefore have a higher expected return than shorter term bonds.
Low quality bonds are subject to the risk of default, and therefore have a higher expected return then high quality bonds.
The difference in returns among portfolios is largely determined by relative exposure to these five factors. Investors who want to earn above-market returns must take higher risks in their portfolio. The cross-hair map on to the right illustrates that tilting a portfolio towards small cap and value stocks increases the exposure to risk and expected return. Decreasing this exposure relative to the market, results in lower risk and lower expected return.
Based upon these five fundamental factors, it becomes possible to custom tailor portfolios of stocks and bonds to each clients various risk profiles. At one extreme is the investor with a high risk tolerance who might have a portfolio of all stocks with a strong bias to small company and value stocks. At the other extreme is an investor with little or no risk tolerance who might have a portfolio with a strong bias to fixed income securities like bonds.
Exercise Patience and Discipline
Our natural instincts can become our own worst enemy when it comes to investing. This is illustrated below in the annual study conducted by Dalbar, a leading financial services market research firm. Over a 20 year period, the S + P 500 Index outperformed the average investor by over 5% a year. The average bond investor underperformed the Barclays US Aggregate Bond Index buy almost 6%.
How is this possible? The simple answer is that we tend to buy stocks and bonds after their prices have risen. We do this simply because we feel more confident and comfortable when markets are up. Similarly, when markets sell off, fear sets in and we tend to sell. This behavior results in our buying near market tops and selling near market lows, thus failing to capture the market rate of return.
The solution to this negative cycle is to keep your emotions out of the investment process.
Stay focused on the long term
- Short term stock picking and market timing can wreak havoc on your long term investing success.
- Make sure you are guided by an investment policy statement.
Regularly review your portfolio
- Make adjustments based on changes in your life not on short term gyrations in the markets.
- Rebalance your portfolio periodically to keep your portfolio aligned with your investment goals.
Don't go at it alone
- An independent Financial Advisor can help you stay on track and focused on your long term goals.
