Retirement Investing #3: The 4 Primary Drivers of Stock Market Returns
13:05 Share

Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte, and today I'm tackling part three of our series on investing in the stock market. And this is where we get to the fun stuff. Today, I'm going to share what historical data you might use when trying to determine the stocks to invest in. In fact, this data is what many of the top money managers in the

world used to intelligently allocate their clients' assets. So if you want to learn how to research the stock market in plain English and build a world-class retirement portfolio, this episode is for you. For all the links and resources mentioned today, head over to youstaywealthy.com forward slash 83.

Okay. As you all know, there's no crystal ball. Nobody knows the future and I'm not making any predictions or recommendations today. That said, history does have a weird way of repeating itself. And the principles that I'm sharing today, once you learn them, will make a lot of practical sense, which is why I think they're widely relied upon in the investing world.

Now, before we get into the weeds, I want to first define the term risk-adjusted returns because it's really important when thinking about portfolio construction and investing. So most people only talk about the returns that they're getting in the stock market or the overall returns that they need to reach a certain goal.

For example, you might hear your friend or neighbor say, I bought Tesla stock and I'm up 50% or I'm up 100%. Or you might hear CNBC one day with their daily update saying something like, this year, year to date, the S&P 500 is up 10%. Or you might be working on your retirement plan and you find out that you need an annual 6% rate of return on your investments to reach your goals.

The key ingredient missing from all these statements is the amount of risk that you're taking to achieve that rate of return. I'm willing to bet if you had a choice, my guess is that you would prefer to take as little risk as possible to achieve that 6% rate of return. Why would you take more risk to get the same reward? You wouldn't. And that's why it's so important to look at and discuss risk-adjusted returns because

When you factor the level of risk into a historical or expected rate of return, you come up with the risk adjusted return. Now, the most common measure of risk, which you probably heard thrown out before is standard deviation. And you can use the standard deviation and the historical or expected rate of return of an investment to calculate something called the Sharpe ratio. And the Sharpe ratio will tell you how much risk you're taking to achieve a certain rate of return.

In general, a higher Sharpe ratio means you're getting a more attractive risk-adjusted return. The good thing is if you're investing in funds like we talked about on the last episode, you don't have to figure out how to calculate the Sharpe ratio. The Sharpe ratio is given to you by the fund company in that fancy fact sheet that you can find on their website or even on a website like Morningstar.com.

You can improve the Sharpe ratio of your portfolio through very simple things like basic diversification and not putting all of your eggs in one basket. You can also improve it by better understanding the different drivers of stock market returns and understanding these drivers will help you decide what asset classes have the best odds of producing attractive risk adjusted returns going forward into the future.

Thousands of peer-reviewed academic studies and decades of research has concluded that there are four primary drivers of stock market returns. And those four primary drivers are one, the market, two, company size, three, relative price, and four, profitability. So let's dig into each one of those.

The first one, the market is pretty easy. In general, let's just say there are two markets you can invest in, the stock market and the bond market. The stock market is riskier than the bond market. I know you guys all know this. So the stock market is riskier than the bond market, which means you should expect a higher rate of return investing in stocks than investing in bonds.

And in the investing community, in the academic world, we call this the equity premium. You get a premium or some extra return by taking your money out from underneath your mattress and investing it. So the market you invest in is the first driver of future returns. The second driver is company size. And this is also pretty straightforward.

small companies are riskier than large companies. So when you're investing in the stock market, you would expect a higher rate of return if you invest in small cap stocks versus large cap stocks. You're not going to go put your hard-earned money into some no-name biotech firm that may or may not be around in 10 years just to get the same boring return that Coca-Cola is expected to give you.

So to recap, the size of the companies you choose to invest in is the second driver of stock market returns.

The third is relative price. And this is a little trickier. Academic research going back to 1928 concludes that value stocks produce higher rates of return than growth stocks. A value stock is a company that's unloved and unfavorable. It's a company that's trading at a lower price than what the company's performance might indicate.

One of my favorite Warren Buffett quotes of all time, I think summarizes value investing really well. Warren says, it's far better to buy a wonderful company at a fair price than a fair company at a wonderful price. He also says, you have to pay a very high price in the stock market for a cheery consensus. In other words, if everyone agrees with your investment decision, then it's probably not a good one.

In that sense, value investing can be labeled as a bit contrarian. As a value investor, you're not going to end up with Tesla stock and Amazon and Netflix. You're not going to end up with those stocks in your account, which can be hard for a lot of people when those stocks are posting double and triple digit returns and everyone around you is making money.

But value investors are smart and patient, and they're investing for the next 10 years, not 10 minutes or 10 days or 10 months. So to summarize, value stocks historically have done better than growth stocks, not every year, not every decade, but over long periods of time.

This makes the relative price of a stock the third driver of returns. The fourth driver is profitability, and this is much less controversial. This essentially says that high profitability companies have done better over long periods of time than low profitability companies. You probably didn't need a PhD to tell you that, but it still never hurts to have the data to prove it on paper. So the fourth driver is profitability.

To recap, the four primary drivers of stock market returns are market, company size, relative price, and profitability. With that out of the way, let's put some numbers to each of these drivers of returns and some of the statements I just made. So let's start with the first one, the market.

From 1926 to December 2018, so 92 years, the research looked at all the 10-year rolling time periods during that time. So 991 different 10-year rolling time periods.

And what it found is that 85% of the time, U.S. stocks provided a higher rate of return than cash. Again, not very surprising. If you're going to take your money out from underneath the mattress and put it in the stock market, you're expecting a higher rate of return most of the time. And that's what the data says. 85% of the time through all these different 10-year rolling time periods, U.S. stocks have provided a higher rate of return than cash.

The second driver is relative price. So for the same time period, those 991 different 10-year rolling time periods over 92 years, the research found that 83% of the time value stocks did better than growth stocks.

Over 73% of the time, small cap companies did better than large. And 99% of the time, high profitability companies outperformed low profitability companies. Probably not super surprising there. If you want to dig in a little bit more to some of those numbers, I'll link to everything in the show notes, which you can find by going to youstaywealthy.com forward slash 83.

Now, before I let you go, I couldn't publish this episode without mentioning the elephant in the room, the elephant being value stocks, which if you're following these closely in the U.S., value stocks have been underperforming now for 12 years. Yes, for 12 years, growth stocks have been doing better than value stocks.

And this has made many investors conclude that all of the research I just shared with you isn't relevant anymore. And the world is now different and value investing is dead. The one thing I didn't share with you yet is why the four drivers of returns are what they are. In other words, what criteria did they have to meet in order to make the list and be agreed upon by most of the academic community? So the criteria are as follows.

One, they have to be sensible. Two, they have to persist across long periods of time. Three, they have to be pervasive across markets and asset classes. In other words, they can't just show up or work in the US. They can't just show up or work in large cap stocks, but they need to work across the globe in international stocks and in different asset classes. So they have to be pervasive across all markets and asset classes.

Number four, they have to be cost effective. So they might work in the textbook, but maybe they're too expensive to actually go and implement in real life. So these drivers have to be cost effective. And then lastly, they have to be robust.

So back to value stocks, for the value premium to have been labeled as a primary driver of return, the evidence needed to prove that it's sensible, persistent over the long term, pervasive around the globe, cost effective to implement, and robust to different metrics used to measure the value of a company.

So you can measure the value of a company different ways, things like the price to earnings ratio, price to book, price to cashflow, dividend yield, and there are others. So it has to be robust to different metrics used to measure the relative value of a company.

And since the value premium met this criteria, I'm in the camp that says the data should be relied upon for long-term investing. And the conclusions in academic research are not a result of cherry picking or just some random outcome. Now, this is not a recommendation, but

But personally, I would view the current underperformance of value stocks as an opportunity. Like here we have this unloved and beaten down asset class. There's no cheery consensus. You couldn't find a cheery consensus out there if you tried. If I'm trying to identify an asset class with higher expected rates of return in the future, I might point to value stocks as one of those asset classes.

That said, it's important to note that I'm willing to be patient and disciplined and commit to this approach. As Warren Buffett famously said, his favorite holding period is forever. He didn't build wealth by jumping in and out of companies or jumping in and out of asset classes or jumping out of growth and into value and out of value and back into growth. No, he buys good companies at a discounted price, i.e. value.

and holds them for a long period of time through thick and thin and through all the ups and downs. As my friend Colin Roche once said, the stock market is the only market where things go on sale and all of the customers run out of the store.

For all the links and resources mentioned today, head over to youstaywealthy.com forward slash 83. Next week, we will have part four, our final part of the four-part series on investing in the stock market, where we're going to put all these pieces together. And I'm going to talk about how do you actually go and implement this successfully. So I hope you enjoyed today's episode. I hope it was helpful and you learned something new and I will see you back here next week.

This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services. ♪