Everyone knows that, over time, financial markets usually deliver a return. After all, we wouldn’t invest in them if they didn’t. But have you ever stopped to think why markets tend to go up, rather than down, over the long term?
In short, investors are rewarded for providing the financial capital that feeds human enterprise. More specifically, they’re compensated for the level of risk they take in doing so.
But there’s more to it than that. Over the last three decades, academics have identified several different types of risk that stock and bond investors are exposed to; they’re also called risk factors or risk premiums.
My colleagues and I recently produced a four-part video series for Independence Advisors in Pennsylvania, called Evidence-Based Investing Insights, which briefly explains the research that underpins the evidence-based approach. In this, the third video in the series, we set out the seven different risk factors — five for stocks and two for bonds — that researchers have established.
The fund management industry likes us to think that it possesses some secret sauce, or special ingredient. But there’s actually no magic to it at all. Ultimately, these are the factors, outlined in this video, that drive investment returns.
In the very few instances where active managers have outperformed over the long term, the reason is usually that they’ve simply taken on more risk by tilting towards one or more of these different factors. The good news is that you can capture these premiums far more cheaply and efficiently yourself, or with the help of an evidence-based adviser.
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Here are Parts 1 and 2 in case you missed them earlier: