What has done well in the five years since the financial crisis? The chart below shows 5-year average annual returns for an admittedly haphazard selection of assets, styles, sizes, sectors, countries, and index providers. US real estate investment trusts did remarkably well and were followed closely by mid-cap value and small-cap growth stocks. U.S. stocks certainly did better than most of the world. At the other end of the spectrum, Brazilian stocks and gold miners performed dismally.
Whenever you see these charts the temptation is to try to pick next year’s winners. But looking at a single time period is just that – a single randomly selected time period – and much depends on how you define your market segments. More important, trying to rotate in and out of narrowly defined sectors at just the right time is a thankless task – and we’ve never seen anyone who could do it successfully.
In the long term we know there are sources of outperformance that persist over time. Two factors that many agree on is size and value. That is, small stocks beat large stocks, and cheap stocks beat expensive ones. This phenomenon shows up across time periods and across countries,
Why does it happen? It’s actually a source of wonderment in the financial world. After all, if people know about an anomaly, they should jump in and earn excess return, and eventually, the advantage disappears. Since this hasn’t happened, researchers have looked for explanations in two areas: risk and human behavior.
Outperformance can happen either because outsized risk is being taken or because something causes an extreme mispricing which eventually gets corrected. But researchers haven’t found evidence that higher risk accounts for the outsized returns of small and value stocks. While small stocks do carry higher risk than the market, this doesn’t fully account for all the excess return they enjoy. And value stocks often show up as having similar or even lower levels of risks than the rest of the market.
On the behavioral side, the idea is that people are behaving in ways that make certain parts of the market more “mispriced’ than others, and outperformance and underperformance then happen when those prices correct. For example, many institutional investors are too large to invest in small stocks, and Wall Street won’t cover them -- so small stocks can languish neglected and mispriced for a long time. On the value side, several studies have shown that people overreact to bad news. That means value stocks hit with bad news can fall far below their worth, giving them more room to outperform later.
More recently, other factors for outperformance have been proposed. One is momentum – or the idea that stocks that have been doing well keep doing well. Another is liquidity – where illiquid or thinly traded stocks do better than heavily traded stocks. While it may seem that illiquid stocks are another way of saying “small” and “value,” Robert Ibbotson of Yale and his colleagues have recently shown liquidity to be a separate factor. The table below shows the co-authors’ work on how four factors affect performance over a 4-decade period.
A critical point to remember in all this is that patience and a long time horizon are key to using any of these factors. Another is that if human behavior is indeed creating outsized opportunities, then behaving differently from everyone else can be profitable.