Pursuing a Better Investment Experience – Decision 5: Consider the Drivers of Returns
Rather than viewing the market universe in terms of individual stocks and bonds, investors can define the market along the dimensions of expected returns to identify broader areas or groups that have similar relevant characteristics.
This approach relies on academic research and internal testing to identify these dimensions, which point to differences in expected return.
In the stock market, the dimensions are size (small cap vs. large cap), relative price (value vs. growth), and expected profitability (high vs. low). In the bond market, these dimensions are credit quality and term. The return differences between stocks and bonds can be considerably large, as can the return differences among a group of stocks or bonds.
To be considered a dimension, it must be sensible, backed by data over time and across markets, and cost effective to capture in diversified portfolios.
In a dimensions-based approach, capturing returns does not involve predicting which stocks, bonds, or market areas are going to outperform in the future. Rather, the goal is to hold well-diversified portfolios that emphasize dimensions of higher expected returns and have low turnover.