Just when I think I have everything figured out, I get hit with a theory that shakes my confidence.
The latest example was the notion that the least-volatile companies generated better returns over a 20-year period than companies whose values experienced greater fluctuations. Whoa! That flies in the face of everything that I ever learned about managing money.
The so-called Modern Portfolio Theory holds that companies with more risk will generate higher returns over long periods of time than more stable companies. In fact, small company stocks, on the whole, have averaged approximately 12 percent per year versus just 10 percent per year for large, established value-oriented companies. An explanation for this was the notion of risk and reward: the more risk, the higher the reward. It stands to reason that the only motivation for investing in something that was clearly more risky was the experience, borne by history, of earning greater returns.
What the Modern Portfolio Theory failed to factor in was best summarized by writer John D. Spooner's investment classic, "Do You Want to Make Money or Would You Rather Fool Around?" It's entirely possible that people knowingly invest in smaller companies involving more risk for reasons having to do with entertainment rather than an expectation of greater returns.
When we talk about stocks that involve more risk, this means small cap mutual funds for most of us, because it's through funds that we accomplish most of our stock market investing. Small cap funds invest in one of three kinds of small companies -- "value," "growth" or "blend."
Of the three types, growth is considered to be the riskiest. This is because growth-oriented companies borrow all that they can get their hands on and they reinvest any profits into more people, more capital equipment, more advertising, etc. -- all in an effort to grow as fast as possible. It's often their leverage created by borrowing that makes their stock prices so volatile. It's also what makes them so profitable when things go well.
So, my ears pricked up when I read the fact from investment analyst Robert Haugen that in all stock markets in the world, from 1990 to 2011, the average return on the least volatile stocks outperformed the most volatile stocks by a total of 17 percent. This meant that someone investing in just sleepy, boring stocks during that 20-year period would have had something approaching 20 percent more money after just 20 years.
As reported by Jeff Benjamin in InvestmentNews, the research goes on to point out that large, value-oriented companies win by not losing. They may not do as well when markets are hot, but they hold their value better in down markets. I could dispute the findings based on my research, but let's go with the flow.
The time period is important. Some may recall that the 1990s saw a tremendous increase in stock values -- averaging 16 percent per year -- and that the S&P 500 index outperformed 95 percent of all other mutual funds. That index, dominated by about 50 companies that make up half of its value, created a self-fulfilling prophesy as its spectacular results just attracted more and more money, which drove large-company stock prices ever higher.
The Dow Jones industrial average offers one of today's purest expressions of low volatility investing. Some research shows that the Dow (including its reinvested, healthy dividend payout) has rarely had a 10-year period when it lost money. During longer rolling time periods, no other single investment type has done as well.
To create a Dow Jones index fund, the best approach is a do-it-yourself chore. Just buy the 30 stocks that make up the Dow, and don't pay anything to have them managed. Then, buy a rake and rake in the dividends every quarter. The "takeaway" here is that investing doesn't have to be complicated. Just when we think we need to get up to speed with Modern Portfolio Theory, there's a credible argument for leaving well enough alone.
Keep It Simple, Stupid (the KISS theory) is an approach that serves people well enough. In my experience, some of the most successful investors of the "great generation" were those who bought some big company stocks 50 years ago and then never touched them. That can work well, and maybe this latest research explains why.