How an evidence-based approach to investing may help your portfolio mix

For those of you who read my column regularly, you know my approach to structuring an investment portfolio is based on the principle of “evidence-based investing.” This is the detailed use of the best current evidence in making decisions about designing individual investment portfolios for physicians. Studies in peer-reviewed journals, by both practising investors and academics alike, have brought us to a better understanding of what risks are worth taking and not worth taking when deciding on the allocation of your investments.In a new study titled “The Other Side of Value: The Gross Profitability Premium” (soon to be published in the Journal of Financial Economics), Dr. Robert Novy-Marx (PhD), an assistant professor of finance at the University of Rochester in Rochester, N.Y., suggests traditional “value” investing may be enhanced by adding a little bit of the “growth” style of investing.First, let’s compare and contrast these two different investing styles.Value investments are characterized by a lower-than-average stock price, higher debt and weaker financial performance. Growth investments, on the other hand, are the exact opposite; these companies tend to be more expensive to buy, have lower debt and have demonstrated stronger financial performance.Why would less successful companies be more desirable to own than more successful companies? Because less financially successful companies are viewed as more risky. And in finance, more risk should equal more return. That is, taking more risk in your investment portfolio suggests you will have a higher expected return over the long-term.According to research by Dr. Eugene Fama (PhD), a professor of economics at the University of Chicago, and Kenneth French (PhD), a professor of finance at Dartmouth College in Hanover, N.H., value companies as a group have outperformed growth companies as a group in the U.S. stock market by 6.28% a year on average over the last 85 years. There have been some periods where growth investing has outperformed value investing, but value portfolios tend to outperform over time. The results are similar for Canadian and international stock markets—the value style of investing is the clear winner if the time horizon is long enough. This explains the convention of overweighting value companies in a portfolio.In fact, many managers who specialize in value investing pay little attention to highly successful companies in order to invest in the most beaten-down companies, or the so-called “diamonds in the rough.” However, Dr. Novy-Marx’s study suggests that adding the most profitable, largest growth style companies to a portfolio could improve the return of a value investment portfolio over time. The study also indicated the overall variability of the investments was reduced, thus making the portfolio more stable.While adding large and profitable firms to a value-style investment portfolio needs more investigation, this new research may have merit. If the evidence continues to support the idea that large, profitable companies add above-average return to a value portfolio with less volatility, it could be a significant advancement for investment management in general, and value investing specifically.Stay tuned for more information on this topic in the coming months.Alan Acton is a financial adviser in Ottawa and can be reached at alanacton@polarisfinancial.ca, or followed on twitter at @AlanActon.

How an evidence-based approach to investing may help your portfolio mix

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