4 Secrets to Higher Returns

As a quantum physicist by training, I have long held firm to the conviction that underlying every complicated problem exists a simple and elegant structure. As a young physicist, I was attracted to the science of investing when I realized that the capital markets are no exception to this universal truism.

By Darius Gagne, PhD, MBA, CFA, CFP

As a quantum physicist by training, I have long held firm to the conviction that underlying every complicated problem exists a simple and elegant structure. As a young physicist, I was attracted to the science of investing when I realized that the capital markets are no exception to this universal truism.

One of the most well kept secrets by the big Wall Street firms is that the global capital markets work well. In other words, information is transmitted in a highly efficient manner and investors can expect to be rewarded fairly for the risk they take, otherwise there would be no capital deployed. The fact that the global stock market represents over $50 trillion in wealth clearly demonstrates this.

Today, we are going to learn the four secrets to taking good, responsible risk in the financial markets in a way that compensates physician-investors fairly. The work of Nobel Prize candidates Drs. Ken French (Dartmouth College) and Eugene Fama (Chicago University)—“Fama/French”—which includes nearly three decades of analysis of over 80 years of financial market data has firmly demonstrated that almost all returns (96%) can be explained by just four “factors.”

1) Allocate a greater portion of your portfolio from bonds to stocksBonds are always an important part of portfolios, despite the fact that historically stocks have outperformed bonds. What’s great for bond investors is bonds are relatively constant in what they deliver. In fact, when looking at the Intermediate Government/Credit Bond Index, there has only been 1 year since 1973 that these bonds produced a negative return. That said, since 1954 equities have generated a 5.5% premium on average over U.S. Treasuries. Bonds are an important part of most portfolios, but to take risks investors need a healthy mix of stocks.

2) Allocate more equities into “small cap” stocks than “large cap” stocks

Small companies are similar to value companies in that, on average, they are expected to have problems sustaining earnings in the future. This is a source of risk. Since investors won’t invest in risky ventures without being compensated, the market does exactly that—it rewards smaller companies with higher average returns of 2% to 4%.

3) Allocate more equities into “value” stocks than “growth” stocks

Value stocks are essentially those with low expected earnings, but have produced returns 5% to 7% higher than growth stocks, those with strong performance and high expectations, over the years. This often comes as a surprise. From the dot come era, we were lead to think that growth stocks offer the big returns, but again, 80 years of data demonstrates conclusively that value stocks provide higher returns over the long run. This is not to suggest ignoring growth stocks altogether, but rather holding a higher proportion of value to growth.

4) Allocate more equities toward emerging markets

Emerging markets are considered more under-developed nations, such as Eastern Europe, South America, Mexico and parts of Asia. Emerging markets have only been tracked in the past 20 years or so, but provide a unique class of stocks that have delivered very high returns on average, but of course with varying degrees of success. One year returns may be up 40%, the next year down 30%. They provide an important element of diversification, however, and have rewarded investors who can withstand the down years.

And That’s It!

These four “techniques” for achieving higher returns explains (just about) all of your portfolio’s returns—a simple and elegant, yet analytical approach to investing which leaves very little room for other arbitrary “trading strategies,” “investment formulas” or “speculative ideas.” It almost takes the “fun” out of investing. But remember doctors, investing is the disciplined and responsible act of growing your family’s wealth, not gambling with it (that is what vacations in Las Vegas are for). The conclusive analysis of these two leading academic researchers on the sources of investment risk and return has reshaped portfolio theory and greatly improved understanding of the factors that drive performance.

Dr. Gagne was originally a Quantum Physicist, earning his PhD at UCLA in the early 1990s. As a physicist, he developed a rigorous and analytical approach to problem solving, as well as a firm belief that there is simple and elegant solution to every problem. With this experience he was part of a wave of physicist to migrate to Wall Street in the mid-1990s. He started his career on the trading desk at UBS, as well as at Merrill Lynch. His responsibilities then were very similar to what he does today: manage and analyze risk. In 2001, Dr. Gagne returned to California and worked at PIMCO, widely considered to be one of the world’s top investment firms. It was his experience there as a Vice President, Portfolio Manager and Financial Engineer that most directly prepared him to manage his clients’ wealth today. In 2005, he co-founded Quantum Wealth Management, a boutique fee-only practice which integrates Nobel Prize winning research with comprehensive financial planning. He invites comments at www.quantumwm.com or 310-656-5250.