Most asset class funds are designed to track the performance of established “market” benchmarks, such as the S&P 500 (large US company stocks) or the Wilshire 5000 (all US company stocks).
Although such asset classes have consistently generated results superior to those of actively-managed funds and independent money managers, it is important to recognize that many popular asset classes were developed as simple indicators of financial performance, and were not intended to serve as blueprints for actual investment strategies.
Indeed, selecting the appropriate asset class funds and the most appropriate mix of the funds is critical, since a portfolio’s asset mix is the single most important determinant of its performance. Financial economic research has shown that the asset allocation decision explains approximately 95% of the variation between portfolio returns. In contrast, active efforts to “beat the market” – such as market timing or stock picking – tend to have a negative impact over time.
There are three primary “factors” which influence portfolio returns:
- the percentage invested in stocks overall (the “market” factor)
- the percentage invested in large company versus small company stocks (the “size” factor), and
- the percentage invested in “growth” versus “value” stocks (the “value” factor)
It is important to understand how this information is used to develop an appropriate asset allocation for your portfolio, using asset class funds that capture asset class “risk premiums” better than funds based on popular market benchmarks.
Most investors intuitively understand that small company stocks are riskier, in general, than large company stocks. It is less intuitive, however, to recognize that value stocks are riskier than growth stocks. Most investors would agree that the stocks of companies with slower earnings growth, lower product market share, questionable management and other challenges (i.e., distressed or “value” stocks) are riskier than companies with positive earnings projections, strong market positions, solid management and rosier prospects (growth stocks). As a result, value stocks sell at lower prices than growth stocks. A lower price translates into a higher cost-of-capital for these companies, which, in turn, translates into a higher expected return to their investors. Growth company stocks generally sell at much higher prices on average, have a lower cost of capital, and thus generate a lower return on capital for their investors.
Investments and insurance offered through the Trust Department of First National Bank & Trust Co. are not insured by the FDIC, are not deposits or other obligations of, and are not guaranteed by, any bank or any bank affiliate. Investments are subject to risks, including possible loss of principal amount invested.