The Investment Scientist

A Simple Investment Principle

Posted on: December 5, 2010

icarra chart

MZ Capital 40/60 model vs S&P 500

Just like two sides of a coin, the capital market is made up of capital demanders (businesses) and capital suppliers (investors). What for businesses are costs of acquiring capital are for investors rewards of supplying it. It is a simple truth that

Costs of Capital = Expected Returns

Looking through this lens, many capital market phenomena can be explained.

Why small stocks tend to have higher returns than large stocks?

It is harder for small businesses to obtain capital than for larger businesses. They have to pay higher costs of capital than larger businesses ex ante. That’s why small stocks also have higher expected returns.

Why value stocks tend to have higher returns than growth stocks?

It is easier for growing businesses to obtain capital than for those that are not growing. Therefore, their costs of capital are lower ex ante. It follows that growth stocks have lower expected returns.

Caveat

Expected returns are not actually returns. In actual historical returns, small stocks outperformed large stocks about 55% of the time; the rest of the time they underperformed. Value stocks did a little better: they outperformed growth stocks 65% of the time. However, over the long run, actual returns do converge to expected returns.

Take home lesson: don’t chase hot stocks or sectors

If a stock (or sector) is the darling of investors, its costs of capital must be very low. The expected returns must also be very low. Though you may get lucky once or twice, if you play this game often enough, actual returns will converge to expected returns.

The simple principle in actionMZ Capital 40/60 portfolio

This MZ Capital model portfolio invests only 40% in equity. It fell only half as much as the S&P 500 during 2008 and the early part of 2009, but it rallied at about the same rate as the S&P 500 after March 2009. Why? The portfolio has a strong tilt toward small cap value, the part of the market where costs of capital are the highest.

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1 Response to "A Simple Investment Principle"

[…] evidence is consistent with the simple investment principle I advocate: when people are afraid to invest in stocks, the equity costs of capital for businesses […]

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



You may also get his monthly newsletter, or join his Facebook page for regular wealth management insights. Michael's email is info[at]mzcap.com.

Twitter: @mzhuang

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