All investors face choices about what should be in their portfolio. For those who start with academic theory and empirical evidence, the initial choice is to own the entire market. Beyond that, evidence-based decisions can be made to overweight, or ’tilt’ towards, parts of the market with higher expected returns in reward for taking on higher risks. This involves investing in companies where investors are willing to pay a lower multiple of, say, earnings or book value (value stocks) relative to other stocks in the market, or owning smaller companies.
Investors rightly focus on the upside opportunity. Taking a hypothetical ‘tilted’ portfolio with 60% invested in global developed market equities, 20% in global large value companies, and 20% in global small companies[1] over the past 50 years (1975-2024), the tilted portfolio has outperformed the world developed equity markets index by around 1% a year after inflation and hypothetical portfolio costs deducted of 0.3% per year. The former returned 7.7% per annum versus 6.7% for the broad market. That may not sound like much, but £1 invested in the tilted portfolio – through the magic of compounding returns over long periods of time – became £40 compared to £25 over this period. To be fair, over the past 10 years, the tilted portfolio would have underperformed by 1%. But that is the way premia work. If there were no uncertainty as to whether an investor would pick up the premium, there would be no risk in doing so, and thus no reward either.
With their focus unsurprisingly on the upside, investors often miss the additional benefit of tilting portfolios to additional premia. In practice, not all positive premia appear at the same time i.e. they are imperfectly correlated in investment speak. The impact of this is that it should help to smooth the returns from the equity element of a portfolio, but potentially also shorten the recovery from market falls. The chart below illustrates the worst-case outcomes over different horizons in after-inflation terms (which is what investors should focus on) from 1975-2024.
Figure 1: Tilting to value and smaller companies can improve worst-case outcomes
[1] Global developed markets – MSCI World Index (net div.) in GBP, global value stocks – Dimensional Global Large Cap Value Index, global smaller companies – Dimensional Global Small Index. UK RPI to 1/1988, UK CPI thereafter.
Source: Albion Strategic Consulting. Data: Dimensional Returns Web – annualised returns after inflation
Again, these may not seem like very dramatic differences, but small annualised falls in value can become quite big numbers when compounded over time. The chart below illustrates the impact of these worst-case periods on £100 of purchasing power (i.e. how much your money can buy after the impact of inflation has been considered).
Figure 2: £100 of purchasing power and worst-case periods (1975-2024)
Source: Albion Strategic Consulting. Data: Dimensional Returns Web – annualised returns after inflation
Conclusion
Perhaps the starkest insight from these data are that equity markets and inflation can result in material falls in portfolio value over prolonged periods of time. Not all market falls are followed by quick reversals, although many are. Owning an appropriate level of bonds is an important component of many investors’ portfolios, depending upon their own unique circumstances.
The second insight is that the ’downside upside’ of incorporating factor tilts such as value and smaller companies into a portfolio, as illustrated above, can potentially help to defend purchasing power better than simply owning the broad market e.g. through a global equity index fund alone.
The third insight is that premia are uncertain from one year to the next (and that includes the basic premium of owning equities over holding cash). Patience is required when investing, but fortunately most investors have investment horizons that make the rewards from these premia more likely.
Enjoy the upside but also value the ‘downside upside’ of tilting too.
Important notes
This is a purely educational document to discuss some general investment related issues. It does not in any way constitute investment advice or arranging investments. It is for information purposes only; any information contained within them is the opinion of the authors, which can change without notice. Past financial performance is no guarantee of future results.
Products referred to in this document
Where specific products are referred to in this document, it is solely to provide educational insight into the topic being discussed. Any analysis undertaken does not represent due diligence on or recommendation of any product under any circumstances and should not be construed as such.
