The Capital Asset Pricing Model implies that assets with high beta should provide a higher rate of return than those with low beta. High beta assets are such because of a high degree of market exposure: a large amount of correlation with the overall market and high volatility. But, is it possible that high beta assets, with their high volatility, may outperform during market booms and then underperform during times of distress (relative to low beta assets)?
I can’t take credit for this idea, but I thought it was an interesting thought and worth some exploration.
Some of my favorite subjects in grade school were the accounts of famous global explorers such as Magellan and Columbus. The history of these pioneers usually has some attachment to the flat Earth theory–what was thought to be the prevailing thought during the middle ages. As it turns out this sentiment at the time was largely false as the ancient Greeks were among the first to theorize that the Earth was indeed spherical.
This post also appeared on AlphaArchitect.com
So you’re a trend-follower. Great.
But here is a question:
What do you invest in when your rules suggest “risk off?”
Many investors suggest low duration cash or t-bills. Seems reasonable.
But is it optimal?
Perhaps we should invest in longer duration risk-off assets like 10-yr bonds? We investigate these questions and come to the conclusion that keeping it simple is probably the best solution — dump “risk-off” assets into truly low risk assets like cash or t-bills.
Several years ago when I made my first real attempts at managing my own assets the idea of a fixed asset allocation strategy made a lot of sense. Diversify by allocating broadly to a wide range of foreign and domestic securities using fixed income to control volatility. Rebalance regularly, limit transactions as much as possible, and always mind fees. When you run strategies such as these through a back-test the results come out to be fairly decent over many different time periods and market cycles. There is nothing wrong with these strategies, and the vast majority of individual retail investors out there are most likely well served through such investment policies. The difficulty is often finding a strategy that aligns with one’s personal preferences and tolerance for volatility.
The idea of buying stocks that are cheap and holding on as they appreciate in value over time is well aligned with the simple heuristic “buy low and sell high.” This central concept has created, for myself, a natural and intuitive pull towards value investing. The problem is that not all “cheap” stocks eventually go on to appreciate in value. Some are cheap for a reason–they have poor prospects and will likely end up in Wall Street’s corporate boneyard.
Admit it, if you’re using some sort of asset allocation strategy this question has crossed your mind. I’m not talking about indirectly owning Berkshire through a fund*, but a direct concentrated holding of the stock itself. Aside from having one of the greatest investors of all time run your money there are some additional fringe benefits. At the very least it gets you a ticket to the shareholder meeting held in Omaha every spring. Dilly bars anyone? Many have written about various pros and cons of Buffett’s businesses. The shareholder letters are publicly available to anyone who wants to read. But how has Berkshire performed as an asset in the context of an overall portfolio?
The idea of exposing an investment portfolio to various “factors” (i.e. small company stocks, value stocks, etc.) as a means to improve returns has been around for decades. The value premium traces its roots back to the mid-twentieth century with the work of Benjamin Graham. Warren Buffett, a student of Graham, used value investing early on in his career to help build his fortune. Research on the size premium (small company stocks outperforming large company stocks) goes back to early 1980s and the work of Rolf Banz.