...pure market risk is where every investor should begin. That is the way Fama/French envisioned their three-factor model to work, i.e. start with market risk and add value and size risk to it if you want too.
Actually, I look at it the exact opposite way. The FF 5 Factor Model explains over 95% of the returns to a diversified portfolio of stocks and bonds. FF5F has displaced CAPM as the asset pricing model of choice for most investors/analysts based on its significantly improved level of explainability. When making stock & bond investments, ideally we want to use the asset pricing model with the greatest explainatory power as our roadmap
With that in mind, multifactor investors have a multitude of investment options, none of which necessarily predates or supercedes any other. As a matter of fact, I could make the argument that an investor's chief goal is to determine the level of size and price exposure within the context of their equity portfolio, and then
determine how much equity they are comfortable holding relative to fixed income.
For many investors, their relative size and value tilts are as or more important
than their equity/fixed ratio for a number of reasons:
a) over some periods, the relative payoffs to size and (more typically) price are larger than the equity v fixed payoff
b) for many investors, the equity/fixed decision is a moving target...starting off favoring equities, and gradually becoming more conservative with age
The relative size/price decision, on the other hand, is likely a "one and done" decision. If you want to give yourself the greatest likelyhood of capturing the premiums, you probably need to establish a permanent tilt and (as Fama says...) "ride it to the beach".
IMO, a portfolio of market risks is where many investors should end.
US investors who have lived through the 66-82 or 00-07 markets may disagree with you. All Japanese investors of this generation may also have a bone to pick with this contention...
Direct risks (the equity/fixed decision) and dimensional risks (size, price, term, and default) both have and will continue to have random periods where investors don't earn a return commensurate with their assumed risk. But they have very low and in some case negative correlations, so assembling a portfolio that contains a greater number of mutifactor dimensions for a given level of risk should hedge an investor better than just chosing one (beta) and keeping their fingers crossed.
It is very important that all investors understand this (new and seasoned). Those that don't learn history are doomed to repeat it!
I agree that value and size risks are not too difficult to comprehend for experienced investors, but three-factor investing is an advanced strategy.
I guess I just don't see how diversifying internationally or diversifying into an industry specific fund like REITS is LESS advanced than a decision to tilt to smaller or more value oriented shares? Advanced or not, flat out ignoring 2 key variables in the most widely accepted asset pricing model we have seems a bit imprudent.
The tracking error that stems from international diversification or REIT investing is greater than that of domestic small and value decisions
Unfortunately, for less experienced or disciplined investors, when value and small stocks are out of favor, good intentions typically go by the way-side and emotions take over. And we all know what happens when emotions rule investment decisions! As such, many investors would be better off not doing a three-factor portfolio.
. Consider the notorious 95-99:
- Code: Select all
ASSET CLASS Ann RET
S&P 500 +28.6%
US LV +21.9%
US Small +20.5%
EM Markets +2.0%
When you are out of favor, you're out of favor. Sometimes EAFE, EM, and REIT markets tank, and you seriously question your allocation there. Other times, small and/or value stocks languish. Either way, you are going to feel left in the cold. This isn't a basic v. sophisticated thing, its a way of life for investors who maintain strategic asset allocations.
Again, I have no issue with experienced and disciplined investors doing a three-factor portfolio. But I cannot recommend that everyone do it. To assume that everyone is sophisticated is just not reality. And it takes a deep understanding of the strategy to stick with it during long periods of under-performance.
For investors with any reasonable degree of net worth, they owe it to themselves to spend the time educating theirselves on how markets work, and how they can be their own worst enemies when it comes to investing. There is a enormous potential payoff to getting this stuff right over the course of ones lifetime...I just cannot see advocating REIT and Global investing, but yet ingorning the various dimensions of equity markets for fear of complication? Your books are as good as they get, but Swedroe, W. Bernstein, Armstrong and Schuelthesis have also done great work. To completely ignore a major aspect of global markets (small stocks and high Btm shares) just doesn't seem reasonable in even the most basic of investment plans.
Look at DFAs Global Equity funds, for example. Likely designed for the small 401k investor, they offer a tremendous amount of global diversification and reasonable size/value exposure for even those committing $25/month (the same investor I assume your 4 fund portfolio is designed for). I see no reason DFA Global investors should have all the fun!