In addition to the 'equity premium' described previously, academic research has proven that there are 2 other factors which can make an effective contribution to investment returns over the longer term, in the form of the premia which are available for holding 'small' and 'value' (sometimes described as 'under-performing') stocks in a portfolio.
To elaborate on this point, we can consider the popular television series, Dragons' Den. In simple terms, business owners go to see the assembled investors (Dragons) to ask them for an investment of capital into their company in order that they can finance their activities or expansion plans. In exchange for this requested capital, the Dragons will require some of the equity of their business, or in other words, some of the company shares, in order that they can benefit from the future profitability and growth in value of the business. In simple terms, therefore, they expect a return on their investment.
In determining the amount of equity they will require in order to invest their capital, the Dragons will want to investigate the important details of the business, including, for example, how healthy its current financial position is, how good its products or services are and how well the company is being run.
For a large, already successful business with proven profitability and good management, the Dragons will want and expect less equity because they will feel that there is a relatively low risk to their capital in making the investment. On the other hand, for a small, young business in the early stages of development, with an inexperienced management team and little more than just a 'good idea' at this stage, the Dragons are likely to want a far higher share of the equity in order to compensate them for the clearly increased risk to their capital.
This example helps to illustrate the economic principle that because 'small' and 'value' companies carry a higher level of risk for investors, they have higher 'costs of capital' (i.e. it costs them more to raise money to finance their activities and expansion plans via a loan or through issuing shares) than financially healthy 'large' or 'growth' companies.
It therefore follows that a company's cost of capital will be equal to an investor's expected return. Logically, this must be the case, because if an investment in a currently under-performing company had the same expected return as an investment in a strong, profitable company, no-one would invest in the under-performing company and the basic principles of our capitalist society would begin to fall apart because any growth in new businesses, jobs and wealth would be severely restricted.
Whilst research shows that it is possible to increase returns by constructing portfolios with an exposure to 'value' or 'small' company stocks, it should be noted that this will result in an increased level of risk in the portfolio, thus it is important for us and for our clients that the nature of investing, expected and required returns, inherent risk and personal risk tolerance are all considered, discussed and understood.
At Chamberlyns, we have access to specialist, passively managed asset-class funds which are not usually available to retail investors, that aim to capture market returns in a very cost-effective manner as well as the additional returns which are available from 'value' and 'small' company stocks.