What the wise do in the beginning, fools do in the end.
— Warren Buffett
In 1977, Bill James self-published a book he called 1977 Baseball Abstract: Featuring 18 Categories of Statistical Information That You Just Can’t Find Anywhere Else. 75 people found the book of sufficient interest to buy it.1 Today James’ annual edition (now called The Bill James Handbook) is considered a must-read for all serious fans of our national pastime.
James demonstrated, through rigorous research, that certain statistics are more meaningful than others in determining the effectiveness of a player. Among his many findings are that a player’s batting average and the number of homers he hits are not as important as people had assumed. James found other statistics are more vital, namely, the total of a player’s on-base percentage and his slugging average.
James revolutionised the way people think about baseball statistics and how to build a winning team. Today, every team in every major sport employs statistical experts (sabermetricians) on their staff. In his book Moneyball, Michael Lewis explained how Billy Beane, the general manager of the Oakland Athletics, used sabermetricians to build a winning team despite the constraint of a limited payroll.
The Bill James Handbook of finance
James revolutionised the way we think about the game of baseball by assessing which factors are the most significant in determining the impact a player has on the outcome of a game. The publication of the paper The Cross-Section of Expected Stock Returns by professors Eugene Fama and Kenneth French in The Journal of Finance in June 1992, had a similar impact on the field of financial economics.
The Fama-French research produced what has become known as the three-factor model. A factor is a common trait or characteristic of a stock or bond. The three factors are market beta (the return of the market minus the return on one-month Treasury bills), size (the return on small stocks minus the return on large stocks) and value (the return on value stocks minus the return on growth stocks). The model is able to explain more than 90 percent of the variation of returns of diversified U.S. equity portfolios.
Lesser known is that professors Fama and French also provided us with a similar two-factor model that explains the variation of returns of fixed-income portfolios. The two risk factors are term and default (credit risk). The longer the term to maturity, the greater the risk; and the lower the credit rating, the greater the risk. Markets compensate investors for taking risk with higher expected returns. As is the case with equities, individual security selection and market timing do not play a significant role in explaining returns of fixed-income portfolios and thus should not be expected to add value.
Further researched unearthed additional factors
Advances in our understanding of asset prices did not end there. Over the ensuing years, other common factors were found to add explanatory power. Among the leading ones are momentum (the tendency for securities that have outperformed in the recent past to continue to do so for a relatively short period), profitability (the tendency for more profitable companies to provide higher returns than less profitable ones despite higher valuations) and quality.
Quality is a broader trait than profitability. Quality companies are those that are not only more profitable but also tend to have less financial and operating leverage (less debt and lower fixed costs), lower volatility of earnings, high asset turnover (they use their capital efficiently) and less idiosyncratic risk (risks not related to the broad economy).
What was Buffett’s “secret”?
An example of how the academic research has advanced our understanding of investment performance is the 2013 study Buffett’s Alpha. The authors, Andrea Frazzini, David Kabiller and Lasse Pedersen, examined the performance of the stocks owned by legendary investor Warren Buffett’s Berkshire Hathaway. They found that, in addition to benefiting from the use of cheap leverage provided by Berkshire’s insurance operations, Buffett buys stocks that are safe, cheap, high-quality and large.
Their most interesting finding was that stocks with these characteristics tend to perform well in general, not just the stocks with these characteristics that Buffett buys. In other words, it is Buffett’s strategy, or exposure to factors, that explains his success, not his stock-picking skills. That, and because he never engages in panicked selling.
The good news for investors is that the “discovery” of these common factors allows individuals to invest in the same type of stocks as legendary investors such as Warren Buffett — who had been successfully exploiting these factors for decades — without having to do all the research. Instead, they can simply invest in funds that provide exposure to these common factors. One example, the iShares MSCI USA Quality Factor ETF (QUAL), which buys quality stocks, has an expense ratio of just 0.15 percent and, as an ETF, is highly tax efficient.
Implications for investors
The implication for investors is that the academic research has conclusively demonstrated that efforts to outperform the market by either security selection or timing are highly unlikely to prove productive after taking into account the costs, including taxes, of the efforts.
For example, studies such as the 2010 paper by Fama and French, Luck versus Skill in the Cross-Section of Mutual Fund Returns, have found fewer active managers (about 2 percent) are able to outperform their three-factor-model benchmark than would be expected by chance. And that is even before considering the impact of taxes, which for taxable investors is typically the greatest expense of active management (greater than the fund’s expense ratio and/or trading costs).
Three steps to success
The prudent strategy, therefore, is to:
1.Develop a portfolio that reflects your unique ability, willingness and need to take risk. The equity portion should be globally diversified across multiple asset classes. The fixed-income portion should be diversified in terms of credit and term risk, as appropriate.
2. Avoid the use of actively managed funds. Instead, invest in funds (such as index funds) that provide systematic exposure to the factors you seek exposure to, such as index funds, which are low cost and tax efficient. In the case of fixed-income assets (for those individuals who have sufficient assets to do so), build a portfolio of individual Treasury securities and/or FDIC-insured CDs, and for taxable accounts, AAA- and AA-rated municipal bonds that are also either general obligation or essential service revenue bonds. Doing so greatly reduces the credit risk and therefore the need for diversification (which is the benefit of a mutual fund). Those strategies will save you the expense of a mutual fund as well as allow you to tailor the portfolio to your unique state and tax situation.
3. Have the discipline to stay the course, ignoring the noise of the markets as well as the emotions caused by the noise—emotions that cause investors to abandon even the most well-developed plans.
The moral of the tale
Intelligent people maintain open minds when it comes to new ideas. And they change strategies when there is compelling evidence demonstrating the “conventional wisdom” is wrong.
Why are some individuals unable to make a change in the face of what some would consider convincing evidence? One explanation is that when you are familiar with a certain way of thinking about a subject, whether it’s investing or baseball, it is hard to make the leap to another model.
Making the leap, however, is well worth the effort, as the Boston Red Sox demonstrated. In late 2002 they hired Bill James as a senior baseball operations adviser. In 2004, the Boston Red Sox won the World Series, breaking what some consider one of baseball’s most famous curses, as well as my heart — I am a diehard Yankees fan (the Yankees are the only team in history to blow a 3-0 lead in the League Championship Series).
1 Michael Lewis, Moneyball (Norton 2003), p. 67.
LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
Want to read more of Larry’s insights? Here are his most recent articles published on TEBI:
When even the best are unlikely to win
Sport, investing and the paradox of skill
A strategic approach to rebalancing
The cost of anticipating corrections
A cautionary tale about chasing performance
Markets are more efficient than you think
OUR STRATEGIC PARTNERS
Content such as this would not be possible without the support of our strategic partners, to whom we are very grateful.
We currently have three partners in the UK:
Bloomsbury Wealth, a London-based financial planning firm;
Sparrows Capital, which manages assets for family offices and institutions and also provides model portfolios to advice firms; and
OpenMoney, which offers access to financial advice and low-cost portfolios to ordinary investors.
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We are currently seeking strategic partnerships in North America and Australasia with firms that share our evidence-based and client-focused philosophy. If you’re interested in finding out more, do get in touch.
