Recently, I came across an academic paper with an attention-grabbing title: “It has been very easy to beat the S&P 500.” Not just easy, but very easy.
That got my attention because, in recent years, beating the S&P 500 has been anything but easy. In fact, it’s been maddeningly difficult. In eight of the past ten years, domestic markets have outperformed international markets—by a wide margin. A dollar invested in the S&P 500 ten years ago would be worth $4.37 today. But if you had invested that same dollar in overseas markets, it would be worth barely half that.
So if there’s a simple formula to do even better than the S&P 500, what is it?
It turns out that this paper doesn’t break any new ground, in my opinion, but it does serve as a useful reminder that the investment world’s obsessive focus on the S&P 500 is somewhat arbitrary. Just as stocks and bonds have performed very differently, so too have different kinds of stocks. While there’s no guarantee that the future mirrors the past, there is indeed a formula which has demonstrated success over many years.
In fact, this formula has been understood since 1992, when two University of Chicago professors, Eugene Fama and Kenneth French, published what is now known as the “Fama-French three-factor model.” Their insight was both simple and profound: They found that just three factors explained a large part of the performance of stocks:
1. The first factor is the performance of the overall market.When the overall market is rising, most individual stocks rise along with it. And when the overall market is falling, most individual stocks fall as well. They don’t all move in perfect lockstep, but in general, stocks do tend to rise and fall together.
2. The second factor was the size of the company. Specifically, the stocks of small companies tend to outperform those of big companies. If you think about it, this makes logical sense. Consider a company like Apple, with $250 billion in revenue. How likely is it that they could double in size from here? It’s possible, but hard to imagine, and it would certainly take a long time. Now consider a smaller company, one with $250 million in revenue instead of $250 billion? How likely is it that this smaller company could double in size? It’s not guaranteed, of course, but it’s much easier to imagine. That’s the nature of smaller companies; on a percentage basis, it’s just much easier for them to grow.
3. The third factor is valuation. In simple terms, high-flying stocks don’t fly high forever. Eventually they lose steam, fall behind and actually underperform over the long term. Why does this happen? In general, Wall Street and the media focus their attention on innovative, exciting companies—like Netflix, Under Armour or Tesla—and don’t give nearly as much attention to older, more mature companies, whose stories aren’t as exciting. The result of all that attention is that it can drive up the prices of popular companies to unwarranted levels. This sets them up for a fall—and when high-flying stocks fall, they fall hard. Meanwhile, the more mature, more boring companies just keep doing what they’re doing, which is to generate reliable profits, leading their stocks slowly but steadily higher. And that’s why, on average, over time, boring companies with low stock prices tend to outperform exciting companies with much higher prices.
That, in short, is the formula discussed in this paper. And while I would never call any type of investing “ very easy,” it has worked historically.
Since Fama and French’s original work in 1992, they and others have uncovered additional factors that correlate with higher stock returns. These include companies with higher profitability, stock price momentum and stock price stability, among others.
This raises a question: Should you fill your portfolio with investments tied to one or more of these factors? In short, my answer is yes, but not too many. When Fama and French made their original discovery, it was a valuable insight. If, however, you build a portfolio that includes too many different factors, you run the risk of creating an unpredictable stew. Perhaps they will work together in harmony, but they’re just as likely to offset each other, or to compound losses when the market declines. That’s why I have a simple recommendation: If you’re looking to build a portfolio, start with a total-market approach, then add only Fama and French’s two original factors, small-cap and value, and nothing else.
Is that recipe going to make it “very easy” to outperform? As I said, nothing is easy, but I do think it stacks the odds in your favor.