There are certain beliefs widely accepted among financial academics and practitioners as truths:

Risk and return are related
Diversification is good
Markets are unpredictable in the short term

Beyond that, most issues remain unproven and hotly contested. The two leading academic views can be summarized as those who believe that markets are efficient (or at least largely efficient) and those who believe in behavioural finance which supports the notion that investors are not always rational. (We believe that, while markets are largely efficient, individual investors display irrational behaviours and the markets can become subject to fads and mass hysteria).

Fortunately, whichever is the case, the best way to deal with it is the same:

Invest for the long term (buy and hold)
Diversify
Minimize fees, taxes and transaction costs

The Three Factor Model

Most of the practised science of finance is based on the Capital Asset Pricing Model (CAPM). In overly simplistic terms, it states that the return on a security or portfolio is equal to alpha (which is the incremental return generated by superior security selection) plus beta times the market return (where beta is the ratio of the volatility of the security or portfolio vs. the volatility of the market). Since alpha is assumed to be zero (if all investors in total are the market, they must on average equal the market - before fees and transaction costs), and the return on the market is a given, this formula boils down to beta, or the volatility of the security or portfolio being considered relative to market volatility. This is a one-factor model.

Unfortunately, it only explains approximately 70% of the price movement of the dependent variable. Eugene Fama and Kenneth French have built on the principal of CAPM with their three-factor model. They discovered that two other variables also help explain returns: size and book-to-market, which is really a measure of the health of a company. Together, with beta, these three factors explain over 90% of returns.

Intuitively, these factors make sense - smaller companies are generally perceived to be riskier than larger companies and less healthy companies (commonly referred to as value stocks) should be riskier than healthy companies (or growth stocks).

At least it makes sense that they are riskier, but why does that imply that they should have a higher expected return? First, remember that risk and return are related. But more specifically, it is a function of cost of capital. The riskier a venture, or loan, or security, the higher its cost of capital is - investors demand a higher expected return for taking more risk. (for more on this, read The Cocktail Party Fallacy, by Eugene Fama Jr.)

This has significant implications for the investor. If small cap stocks and value stocks have a higher expected return than their respective counterparts, why not invest in them? The catch of course, is that they come with the higher volatility - they are riskier. But these are risks that you get paid to take. So doesn't it make sense to reduce other sources of risk so that you can accept these higher risk levels?

That is in fact exactly what we do. By controlling the amount of volatility from fixed income investments, and controlling risks that don't pay, such as currency risk, we can increase exposure to these factors and therefore increase expected return without increasing the risk level of the portfolio (in fact, often reducing it). That is what we call spending risk dollars wisely.

For more information on the three-factor model, click here.