Structure Explains Performance
Investing isn’t just about the stock markets, as we’ve already discussed diversificiation is key.
In addition to the three factors or dimensions that explain equity market risk and return, Fama and French added a further two dimensions which explain fixed interest returns. They are:
• The Term Factor: the difference between long-term government bonds and short-term Treasury bills.
• The Default Factor: which measures the difference between long-term corporate bonds and long-term government bonds, assuming that governments are less likely to default than corporations.
Whilst the Term Factor provides higher expected returns, the excess returns diminish significantly beyond a term of five years, so bonds with terms in excess of five years are generally avoided.
Fixed interest investments are an important component of investment portfolios because they dampen portfolio volatility due to their low correlation to the movements in share prices. Fixed interest investments (i.e. Gilts and Bonds) also provide investors with short-term liquidity where cash distributions may be required from the portfolio over a two to four-year period.
Equipped with the three risk factors of equities and the two risk factors of bonds, it is possible for investors to select from a wide array of risk and return combinations when building efficient portfolios. The resulting trade-off is known as the “eat well/sleep well dilemma.” If investors want to eat well and earn higher returns with stocks they need to be prepared to take more risk and accept the roller-coaster ride of fluctuations in the value of their portfolio. If they want to sleep well, they must take less risk and invest in fixed-income investments such as bonds and accept that they will earn lower returns.
The blending of these components in an investment portfolio is called Asset Allocation.