Everyone who invests has the same question: how can I beat the market? There actually is a way, but it has nothing to do with actively trading stocks, which as I have already said is a fool’s game.
You’ve probably never heard of this particular method of beating the market. This might make you suspicious of it—why isn’t it advertised and talked about more? The reason is that stockbrokers and other investment management professionals haven’t been able to develop any way to make money off of it, so they’d rather have you use other methods to attempt to beat the market, such as active trading, that compensate them better.
The methodology is based on the work of Eugene Fama and Kenneth Sharpe from the University of Chicago. It is called “The Three-Factor Risk Model.” It is well accepted that you need to take stock market risk to obtain higher investment returns, and so equity risk is the first of their three factors. You will not get high returns investing in non-equity instruments such as money market funds, CD’s, high quality bonds, etc. The breakthrough that Fama and French developed is that you can also earn consistently higher returns by investing in small cap stocks and value stocks—the other two factors in their three-factor risk model. “Small cap” stocks are simply smaller firms, and “value” stocks are lower priced stocks (relative to earnings).
Small cap and value stocks have earned 3 – 4% more per year than the overall stock market on average over the last 100 years. Therefore, a “tilt” in your investments towards these types of stocks can result in a nice improvement in your long-term investment returns.
However, as with all things related to the stock market, and economics in general, there is a “cost” associated with these outsized returns. They call it “The Three Factor Risk Model” for a reason. Small cap and value stocks generally exhibit more volatility than the overall market, so if you weight your portfolio towards these you will experience larger swings in your investment balance. Basically, when the market falls, these types of stocks fall even faster and lower, and when the market rises, these tend to rise faster and higher. So you need to have a strong stomach to hold more of these investments.
Most finance professionals recommend you keep no more than 5 – 10% of your overall investments in each of small cap and value stocks. You might go to the upper end of that range if you are a risk taker and have a long time period before you need to use the money (such as a young person saving for retirement), but hold on for a bumpy ride!
The easiest and smartest way to invest in small cap and value stocks is to purchase small cap and value index funds or ETF’s offered by such companies as Vanguard, Fidelity, and T. Rowe Price.
You should seriously consider employing the Three Factor Risk Model with your investments. It is the best and surest way to maximize your investment returns. Every other method is more likely to enrich your stockbroker than you.