2 
2 NOBODY GETS INVOLVED IN INVESTING BECAUSE OF A BURNING desire to manage risk. As important as understanding and managing risk is, it often gets left out of discussions of investing. The concept of risk is opaque and works against our intuition. On the other hand, returns are transparent and highly publicized. There are few industries where a manager’s performance is quoted on a daily basis as happens in the investment industry.
Because performance is quoted on shorter-term time frames like days, months, and quarters, we often neglect to discuss a feature of returns that is relevant across time and asset classes: inflation. Inflation is the general rise in prices that occurs over time. Whether we like it or not, we live in a nominal world, meaning that the wages we earn, the investments we make, and the goods we end up buying are all affected by inflation.
Economists often talk about economic statistics on what they call a real basis. In short, they strip out the effects of inflation to allow for comparisons across economic series, time, and even countries. For example, a period of 5% economic growth is far more impressive when inflation is 1% than when it is 4%. However, this focus on real measures clouds the issue for investors, because investors live in a nominal world.
Rampant inflation has not been a problem in the United States for decades. So for many, the issue of inflation has faded from our collective memories. In one sense, this is a good thing. Inflation can greatly distort the way people collectively make decisions in an economy. Not having to contend with these effects can make for a more efficient economy.
However, for investors, inflation has never really gone away. It is always there lurking in the background. An analogy can help bring the point home. In this increasingly eco-conscious age, people now worry about the “waste” electricity we use from so-called phantom devices. These devices—such as your TV—draw power even when they are turned off. Inflation is a lot like that. Even when we are not paying attention to it, inflation is still there, reducing the purchasing power of your hard-earned savings and investments.
Some might say that we can safely ignore 2% inflation, such as we have seen of late. However, a quick lesson in the power of compounding should dissuade you of this view. In a world of 2% inflation, an investor needs to earn 2% just to stay even with inflation. (We are ignoring the effect of taxes at this point.) After 10 years, that initial dollar invested would have to grow to $1.22 just to stay even with inflation. If you substitute 5% for 2%, you would have to grow a dollar into $1.63 just to break even. This quick example shows you the power of not only inflation but also compounding.
Like many things in life, inflation is something individuals and the economy can get accustomed to. Individuals internalize the effect of higher future prices, workers demand pay hikes, and businesses build into their contracts higher prices to counteract the effects of inflation. In this example, some of the effects of expected inflation can be managed, but the larger costs to society still remain. And what is a bigger danger to investors is unexpected inflation.
When inflation really gets rolling, it can take some time for investors to come to terms with higher inflation. In the meantime, all manner of financial assets, for instance, bonds, get repriced, i.e., get priced lower. From this perspective, the worst-case scenario is a steadily increasing rate of inflation. These recurring negative surprises wreak havoc on asset prices as investors repeatedly try to ratchet up their expectations.
On the other hand, the best-case scenario is one in which inflation is high but steadily declines.1 This reduction in the rate of inflation, or disinflation, represents what happened through much of the 1980s and 1990s in the United States. The wringing out of inflation from the system represented a healthy tailwind to both the bond and equity markets during this time period.
There are some securities these days that take into account the effects of inflation. In the United States these are called TIPS, or Treasury inflation-protected securities. TIPS provide investors with a coupon, or interest rate, over and above consumer price inflation. Other sovereign nations, and a handful of corporations, also issue these types of securities, but they represent a small part of the overall bond market. These securities represent a unique way for individuals to hedge, in part, the risk of higher inflation.2
In the midst of the inflationary decade of the 1970s, Warren Buffett wrote an article for Fortune magazine describing the negative effects of inflation on companies and their shareholders. He makes the point that inflation serves as a tax on investment. Buffett writes: “The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislatures. The inflation tax has a fantastic ability to simply consume capital. It makes no difference to a widow with her savings in a 5% passbook account whether she pays 100% income tax on her interest income during a period of zero inflation, or pays no income taxes during years of 5% inflation. Either way, she is ‘taxed’ in a manner that leaves her no real income whatsoever.”3
Investors need to recognize that taxes play the same role that inflation does for the tax-paying individual. In the investment world, taxes are rarely taken into account when discussing returns. Taxes fall by the wayside in large part because investing entities like pensions, endowments, and even mutual funds don’t pay taxes. They either are tax exempt or simply pass along their tax obligations to their investors. The other complicating factor is that every individual faces a unique tax situation, making it difficult to generalize. Just because the financial media frequently avoids the issue of taxes does not mean you should. Taxes play as important a role as inflation in generating returns over time.
It has often been said that there is nothing certain in this life besides death and taxes. From an investor’s perspective, you can add inflation to that list. Even small amounts of inflation add up over time to degrade returns. What matters for investors is generating real, after-tax returns. Once you recognize the important role that real and after-tax returns play, we can move on to the challenge of understanding how those returns are generated in the first place.
In the desire to generate real, after-tax returns, it would be great if we could count on the financial markets to generate steady, real returns in exchange for taking on financial risk. Academics call the return premium for equities versus bonds the equity risk premium (ERP). However, it is difficult to pin down what the ERP is. At best, we can say that the premium for investing in equities is much lower than it has been. At worst, the ERP is a myth.
Investors need to believe in an ERP. They need to believe that the efforts required to create and manage an equity portfolio should earn them some sort of additional return over time. Otherwise what is the point? Given the importance that the ERP plays for investors and companies alike, you would think that we would have a good handle on it. Unfortunately you would be mistaken.
Aswath Damodaran, who writes extensively on the topic, notes: “Equity risk premiums are a central component of every risk and return model in finance and are a key input into estimating costs of equity and capital in both corporate finance and valuation. Given their importance, it is surprising how haphazard the estimation of equity risk premiums remains in practice.”4 Just how haphazard are these estimates?
Practitioners, companies, and academics are in the same ballpark when it comes to estimating the ERP. Surveys by Fernandez, Aguirreamalloa, and Avendaño show an estimated 5–6% ERP in the United States.5 Given the way finance is taught in the United States, we shouldn’t be that surprised that all the parties in the surveys came in with roughly the same estimates.
What is surprising is just how big a spread there is in the estimates. Estimates of the ERP run anywhere from below 2% on the low side all the way up to 10–15% on the high side.6 You could argue that this diversity in opinion is what makes markets. However, this wide a spread calls into question whether we are in fact talking about the same thing altogether.
What is clear is that estimates of the ERP have been coming down over time. In part that has to do with the poor performance of the equity markets ever since the year 2000. And in part it has to do with a growing recognition that the ERP simply can’t be as high as earlier thought.
For a long period of time, the case for equities above all other asset classes was based on the high ERP seen historically. The ERP was so high that it was classified by academics as the “ERP puzzle.” However, over time academics have been lowering their estimates of the ERP. A survey of academic textbooks by Fernandez shows a 3% decline in the estimated ERP over the past two decades.7 It is safe to assume this estimate will come down even further.
The past decade or so has been a lost decade for U.S. stocks. The poor performance has dragged down all sorts of historical measures of the ERP. In the case of the United States, from 1986 to 2010 the ERP versus bonds has only been 0.9%.8 So for a 25-year period, equity investors earned not even 1% more than long-term Treasury bonds. If you look at this number on a global basis, the number since 1986 is actually negative!9
To get numbers like those seen in the survey data, you have to use data going all the way back to the beginning of the twentieth century. In the case of the United States, Dimson, Marsh, and Staunton find a 4.4% ERP for the United States and a 3.8% ERP for a globally diversified index. Other researchers go back to the beginning of the nineteenth century to generate even longer-term estimates.
There are two issues with going back this far to generate long-term estimates of the ERP. The first is that there are real methodological problems with trying to extract data from back then. There are no computer files one can consult to generate these data time series. Jason Zweig at the Wall Street Journal looked at many of the problems with the old data and found any data before 1870 to be suspect.10 In short, we have data that are a lot less reliable than commonly thought.
Second and more important, what relevance do equity returns from these early periods really have to us today? The process of equity investing was very different back then. It took a much more intrepid investor to invest in equities in those earlier times. Information was scarcer, and the costs were much higher. Equities must have seemed like a much more speculative proposition back then than they do today. Today we have nearly unlimited data, nearly free commissions, and the ability to trade stocks with a mouse click. Today’s equity investor is no longer facing the hurdles an investor a century ago would have faced. We should therefore take these long-run estimates of the ERP with a big grain of salt.
Not mentioned in all this discussion is another issue. All these estimates are based on theoretical returns to some sort of market basket of stocks. While today market baskets, or index funds, are commonplace and transparent, all these estimates of market returns are not necessarily based on investable indexes—again another reason to be skeptical of these estimates.
Given these limitations, the ERP is likely lower than previously thought and lower than most people’s estimates. What if the ERP is even lower than these low-end estimates? As mentioned, the ERP does not take into account certain real-world effects, all of which lead to lower estimates of the ERP.
Eric Falkenstein, author of the book Finding Alpha, has been a critic of the literature on the ERP.11 Falkenstein believes that after you take into account a number of adjustments, the ERP is actually zero!12 For example, index returns don’t take into account the variable dollar flows into equities.13 Therefore, buy-and-hold results overestimate the returns investors actually earned. Another factor not taken into account is taxes, an issue we have already touched on. Falkenstein notes that all these estimates are based on pretax returns and should therefore be lowered for taxable investors. He also mentions a number of other factors, some technical, that serve to reduce the ERP. He notes that any of these factors puts a big dent in the ERP, and when taken as a whole, they make prior estimates of the ERP seem far off base.
This discussion is admittedly abstract and filled with somewhat conflicting statistics. The question of the ERP is important for a couple of reasons. The first is simple. Equities are the linchpin of most people’s long-term portfolios. If the estimates used to justify this status are flawed, we need to understand this. Second, we need to understand the limitations of the ERP. If we can’t trust the estimates many people use to justify a role for equities, then we need to rethink our entire approach to investing.
Then again, you don’t have to buy the case that the equity premium is strictly zero to rethink your approach to investing. If the ERP is more modest than previously thought, it makes the idea of a 100% equity portfolio seem decidedly risky. Blogger and investment advisor David Merkel writes: “One can gain moderately over the very long haul in stocks versus bonds, but with significant volatility. Don’t risk what you can’t afford to lose in the stock market, and other risky investment vehicles.”14 This seems like good advice whether the ERP is 0% or 5%.
There is a big disconnect between the research that academic finance and investment professionals conduct and the real world. The prior discussion of the ERP is a perfect example. Researchers talk about average returns, which, on the face of it, makes sense. How else can we summarize decades of market returns? Unfortunately we don’t live in an average world. We live in a world where we go to work, save, invest, and (the hope is) retire.
Many financial planners move beyond the use of simple average returns with more sophisticated models. To the degree to which these models show investors that they need to spend less and save more, they are useful. However, if they are used to more precisely predict the future outcomes of the market, then they are simply dressing up uncertainty with a false sense of precision.
Everybody’s experience in the markets is unique. Nobody earns the average return of the market. We all are going to experience different market conditions at different points in our financial lives. Therefore, talking about average returns really hides the much more complicated investing equation we all face over time. Nobody lives a perfectly average life. Therefore, nobody lives a perfectly average investing life either.
Peter Bernstein is quoted as saying, “The market’s not a very accommodating machine; it won’t provide high returns just because you need them.”15 In that sense, you can think of the market as a slot machine. Just because you put a quarter in, you are not entitled to a payoff. So in the abstract, we can talk about average market returns, but everyone’s experience with the market is going to be different.
Timing plays a big role in our investing experiences, which is another way of saying that luck matters. A brief review of the history of the markets shows decade-long periods of high and low returns, with few average decades in between. Therefore, investors who are in their prime savings and investing years in the midst of a rip-roaring bull market are going to have a much better experience than they might have over the past lost decade for stocks.
A concept to keep in mind when thinking about investing over the long run is the idea of drawdowns. A drawdown is the reduction in the value of an asset (or market) as the asset falls in price. Once an asset reaches a new high price, the drawdown is complete. Drawdowns are the bane of investors large and small. Drawdowns are best thought of as the manifestation of downside risk. Risk management is in a very real sense an attempt to minimize drawdowns.
Drawdowns are unavoidable. Markets cannot continually reach new highs. The challenge for investors is not the transient drawdown but the ones that last decades and wreak havoc with a portfolio. These drawdowns can greatly harm those who are coming up on significant milestones like retirement. In the past decade for stocks, there has been no shortage of examples of people who delayed their retirement because of the drawdown in the stock market.
The stock market in the United States has experienced a handful of significant drawdowns in the past 100 years. The most notable drawdown was in the wake of the market crash of 1929 and the ensuing Great Depression. The stock market did not recover until 1945. Most recently we have seen two big drawdowns. The first was in the wake of the Internet bubble, the second occurring in the wake of the financial crisis of 2008. Both of these pushed the market down some 50% from its highs.
Equity market drawdowns highlight the importance of valuations. In the case of 1929 and 1999, the equity market was undergoing a bubble. By any measure, the market before starting its descent was richly priced. These high valuations turned out to be an indication that risk was high as well. The subsequent market fall served to normalize the market’s valuation. In the case of 1929, the state of the economy played an important role in the long climb back for the stock market. The economy also plays a crucial role in the performance of bonds.
It should not be altogether surprising that the stock market can undergo long periods of underperformance. What may be more surprising is that the bond market can undergo protracted drawdowns as well. While valuation also plays a role in the bond market, what matters most is unexpected inflation. The entire decade of the 1970s was characterized by high inflation and a decline in the real value of bonds. The ensuing multidecade-long bull market in bonds was a function of three decades of disinflation.
Dimson et al. highlight the role that simple diversification can play in reducing the magnitude of drawdowns in either equities or bonds. They present the performance of a 50:50 portfolio of equities and bonds and state: “Individually, equities and bonds have on several occasions lost more than 70% in real terms. But since 1900, this 50:50 blend has never (USA) or virtually never (UK) suffered a decline of over 50%. Furthermore, the duration of drawdowns is briefer for the blend portfolio than for the supposedly low-risk fixed income asset.”16
They go on to note that this portfolio is a naïve one and that investors would be well served by a portfolio more diversified than a simple 50:50 split. Diversification into international markets could help diversify the risks of any single country. Another surprising diversifier comes to mind as well—cash. James Montier, in a discussion of hedging tail risks, highlights the attractions of cash. As he states: “When constructing portfolios ex-ante, the aim should be robustness, not optimality. Cash is a more robust asset than bonds, inasmuch as it responds better under a wider range of outcomes.”17
We will talk more about cash in a future chapter, but this discussion of cash highlights the importance of what Montier calls a robust solution. The goal of every investor is to survive drawdowns and reach the finish line with portfolio intact. Drawdowns are important not only because of the financial havoc they can wreak but also because of the psychological damage they can inflict. Drawdowns bring out the worst behavior in investors, such as panic. The best portfolio solutions recognize the dangers that drawdowns pose to our portfolios and our behaviors.
In a more philosophical light, we need to recognize that luck plays a big role in investing. Some investors are going to experience muted drawdowns and robust market returns; others just the opposite. The market owes us nothing. The most recent lost decade for stocks shows that the best laid plans of investors can be upended by all manner of calamities.
This discussion of long-term returns glosses over an important point. For investors the long term is really made up of a series of short terms. We can’t get to 10-year or 20-year returns without passing a number of milestones along the way. Therefore, looking at how returns evolve over the intermediate term will give us a better sense of how returns are generated.
Momentum equals mass times velocity. In the context of the financial markets, momentum simply means that stocks and asset classes that performed well (poorly) in the recent past on average continue to outperform (underperform) in the future. Momentum in that sense is about as simple as simple gets when it comes to the financial markets. All you need are historical prices to do the calculations.
There are many ways to calculate momentum. At its most basic level, it involves measuring past performance, usually over a 3-to 12-month time frame, and comparing the performance of a set of assets. The assets with the best past performance are expected to continue that performance in the future. Likewise those assets with the worst performance are expected to continue to underperform in the future. Portfolios are formed accordingly and updated as new returns come in. In this formulation, momentum is an intermediate-term phenomenon. Momentum eventually fizzles out, and mean reversion eventually kicks in.
In our earlier discussion of bubbles and their aftermath, we saw how momentum works at its most extreme. What we are talking about here is garden-variety booms and busts, not bubbles and panics. Markets everywhere undergo these types of cycles. On the face of it, momentum, or relative strength, should not exist. However research by James P. O’Shaughnessey shows it working decade after decade in U.S. equities.18 The patterns we are discussing are very simple, and as trading strategies go, momentum strategies are relatively easy to implement.
Maybe the most intriguing aspect of momentum is that it is such a persistent feature in financial markets. Momentum shows up in all sorts of places, including within and across asset classes. As Antti Ilmanen states, “Momentum strategies perform well in virtually all asset classes we study.”19 If momentum strategies showed profits only in select time periods or geographies, we could dismiss momentum as a phenomenon, but the evidence is too strong that momentum exists.
In a much-cited paper, Asness, Moskowitz, and Pedersen study the existence of value and momentum factors together across a range of asset classes. In agreement with Ilmanen’s statement above, the authors find momentum effects in a range of asset classes.20 Intriguingly, they also find that the returns to momentum strategies in different markets seem to be correlated. As well, they find that momentum strategies perform best in periods of declining liquidity like that seen during financial crises. This jibes with the performance of managed futures during the tumultuous year of 2008.
One thing Asness et al. don’t do is say definitively why momentum exists. Then again, no one really has any single explanation for why momentum effects persist. Most attempts rely on behavioral factors to explain the stylized facts of momentum and the eventual reversal in returns. These include some combination of an underreaction to news and an overreaction to past returns. If behavioral factors are the reason driving momentum, then it is a pretty good bet that it will persist over time.
Momentum strategies have become ever-more popular over time. In part this has to do with education. In their book The Ivy Portfolio, Mebane Faber and Eric W. Richardson discuss how investors can implement strategies based on trailing 10-month returns within and across asset classes.21 On the managed futures side, a book like Trend Following by Michael W. Covel has played a large role in getting the message out about these types of strategies.22 There is more to it than mere publicity.
A structural shift in the financial markets has made the implementation of momentum strategies cheaper and easier than ever before. The emergence of ETFs for nearly every asset class, industry sector, country, currency, and commodity has brought momentum strategies to the masses. Prior to this, momentum strategies were more expensive and difficult to implement. We will see later just how much ETFs have changed the financial markets, but for investors and traders the existence of so many asset classes has been a boon.
One of the more prominent areas where momentum investing takes place is in the commodity futures markets. The managed futures industry is made up mostly of investors who follow momentum strategies in various markets, including commodities, currencies, and equities.23 We will discuss managed futures later in the book, but the success of trend followers has garnered a great deal of attention and capital. The challenge for trend followers has never been in formulating a strategy. Trend-following strategies are pretty straightforward. The challenge has always been one of discipline.
The discipline required to follow a momentum-type strategy is largely overlooked in these discussions. Momentum works because it calls on investors to do things that do not come naturally. Momentum strategies require investors to buy things that have already increased in value and are trading near their highs, not their lows. Successful momentum strategies also have strict and well-defined selling, or switching, strategies. Both these pieces of the momentum puzzle are difficult for investors to master.
There is another piece to the momentum puzzle, and it relates to our earlier discussion of drawdowns. Just as markets and asset classes can have sizable drawdowns, so can strategies. Momentum strategies are notorious for having sizable drawdowns. As noted, not only do large drawdowns have an effect on returns; they have a large psychological cost as well. Momentum strategy followers are plagued by the desire to bail out on the strategy when returns are the worst. In short, the returns to momentum come with a high psychological price tag.
The publicized returns to investments made using mechanical momentum strategies are therefore not necessarily reflective of what we mere humans are able to do on our own. When it comes to implementation, a computer is more disciplined than any human can be. There is some hope though. In the areas of equities and managed futures, new exchange-traded products (ETPs) have arisen that follow momentum strategies. These ETPs take the guesswork and psychological difficulties out of the implementation of momentum strategies for individual investors.
The question for investors is whether these prepackaged momentum solutions will eventually erode the returns obtained with these types of strategies.24 If momentum investing becomes so simple that anyone can do it, the returns gained using the strategy may disappear over time. This possibility is not altogether farfetched. A number of so-called market anomalies have largely disappeared after being studied and popularized.
So if momentum seems to rule markets in the intermediate term, what happens in the longer term? We have already hinted at this earlier, but over the long run, value effects win out as markets come back to reality, or mean-revert. Let’s take a look at the number of ways that valuation eventually comes into play.
If we go back to our discussion of bubbles, we see how markets can move through periods of euphoria when momentum rules. When this momentum reverses, it oftentimes takes prices not only toward fair value but past fair value into undervalued territory. Every market move is obviously not a bubble bursting, but this stylized view of market behavior gives us a clue to the other part of our return puzzle: value.
Just like momentum, value effects are a well-established fact of the financial markets. There are a number of types of value investors, including those that like to call themselves contrarians. One manifestation of value is the reversal effect. Reversals occur over many time frames, but most typically they occur outside the window of momentum—that is, just outside of a year. Longstanding research indicates that those stocks that performed worst over the past three to five years undergo a “reversal effect” and begin outperforming.25 We see just the opposite effect for those stocks that have performed best, with their stocks beginning to underperform.
If reversals didn’t occur, returns would in theory just continue on indefinitely. Expensive assets would get more expensive, and cheap assets would keep on getting cheaper. We know that is not how the world works. Public investors are only one side of the equation. On the other side of the equation are issuers and private investors. These players get paid to recognize when things get expensive and, conversely, cheap.
Think back to the Internet bubble. When things were getting frothy, every company, new or old, that had any business tangentially related to the Internet moved to go public. Those companies took advantage of high valuations to issue overpriced stock. This cycle of initial public offerings (IPOs) has been going on for a long time. That is in part why IPOs in general underperform the market.26 Companies initially issue stock when valuations are high, and the stocks subsequently underperform. If these issuers in a certain sense “sell high,” who buys low?
In some cases, other corporations. If a company’s price gets too low relative to that of its competitors, one of those competitors could make a bid, at a premium, to acquire or merge. Other types of bidders can get involved as well. Over the past few decades, private equity has become an important player in the market for corporate control. If private equity investors see a public company trading at a level at which they believe they can purchase, finance, and operate the company profitably, they will attempt to do so. This sort of real-world activity helps bridge what we see going on in the stock market and the actual market for corporate control.
This is not an equity market phenomenon only. Companies that issue bonds take advantage of favorable market conditions as well. Throughout 2011, corporations issued record amounts of debt, taking advantage of rock-bottom interest rates. With Treasury yields at historically low levels and low credit spreads, some companies with AAA ratings were able to issue bonds at rates not much higher than that of the U.S. government.27 Could rates have gone lower? Sure, but these companies recognized a favorable environment to issue debt and took advantage of it.
From an investing perspective, there are a couple of ways of looking at and implementing value investing strategies. The first takes a more quantitative, or academic, approach; it looks at statistical measures of value to build portfolios. Value-based approaches have been shown for some time to outperform the market. These value stocks outperform in part because their valuations eventually converge with the rest of the stock market.28 The question is whether these statistical approaches can continue to work in an era where knowledge and network effects, which are difficult to value, play an increasingly larger role in companies than plant and equipment do.
David Swensen, head of the Yale University endowment fund, describes these approaches as “naïve contrarianism.”29 In his view, value investing is a more thoughtful process of looking for value in whatever corner of the markets that provides it. This is a more challenging task than simply buying stocks that are statistically cheap. Swensen writes, “In many instances, value investing proves fundamentally uncomfortable, as the most attractive opportunities frequently lurk in unattractive or even frightening areas.”30
Value, or contrary, investing is therefore like momentum investing in that it is psychologically difficult to stick with over time. In the case of value investing, it requires consistently going against the crowd. As noted investor Howard Marks writes: “To boil it all down to just one sentence, I’d say the necessary condition for the existence of bargains is that perception has to be considerably worse than reality. That means the best opportunities are usually found among things most others won’t do.”31 The most successful value investors are able to do things that most investors are unable or unwilling to do and are therefore able to generate returns not available to index investors.
The fact that momentum and value can coexist shows that the investment world is, to say the least, a complicated beast. Some investors do very well plying their trade in either the world of momentum or value. To some degree, this has to do with their investment disposition, as one or the other of these approaches feels right to a certain group of investors. This is an important point, because as we discussed, both these approaches work in part because they are psychologically difficult to follow. Those investors that are best suited to the psychological rigors of either momentum or investing are most likely to succeed with that approach.
For the rest of the world, there is a middle approach, and that involves combining value and momentum in a portfolio. We can look at this in a couple of different ways. Combining value and momentum on a microscale or within an asset class makes these returns less vulnerable to the returns for any single return factor. On a broader scale, it makes sense to combine value and momentum across asset classes in part because the returns for value and momentum are negatively correlated with each other.32
Research indicates that portfolios focused on these strategies can outperform those simply focused on broad asset classes.33 An investor who combines the two approaches has a chance to create a portfolio that provides less volatile returns in an attempt to generate abnormal returns. This is the crux of the matter for investors. Our discussion of risk and return has focused on trying to create portfolios that keep investors on track and in the game. Finding a middle path between momentum and value within and across asset classes gives investors a better chance of creating a portfolio that they can stick with over time.
Investors should never forget that their goal is to generate real, after-tax returns and that inflation and taxes play key roles in our returns.
Estimates of the equity risk premium have been coming down for some time. There are good arguments why we should contemplate and plan for a lower, even zero, equity risk premium.
The market owes us nothing. Investors need to contemplate dealing with significant drawdowns in the equity and fixed-income markets during their lifetime.
Over the short and intermediate term, momentum rules markets. However, following a momentum strategy comes with significant psychological costs.
Eventually momentum fizzles out and value wins out. The links between the financial markets and corporate finance ensure some balance between prices and reality.
Investors have a better chance of earning balanced returns by combining strategies, like value and momentum, in their portfolios.