From the November 2006 issue of Boomer Market Advisor • Subscribe!

November 1, 2006

Escape mediocrity in performance results

The good news is that earning outstanding returns while reducing risk can be accomplished. The catch is that you can't follow the herd of advisors and fund companies that strive, at best, for mediocre returns.

In 1970, Professor Eugene Fama formulated the Efficient Market Hypothesis. This theory suggests that stock prices fully reflect all available information on a particular stock or sector, and therefore, no investor can outperform the market.

The financial community embraced and acted on this theory, as evidenced by the rapid growth in index funds and diversification strategies. Many advisors believe the best they can do for their clients is to diversify their portfolios as much as possible, and then hope for the best. Unfortunately, this notion is further reinforced by most of the available planning software products.

Somehow, in the enthusiasm to protect investors, the industry largely ignored a number of contradictory studies, including one by Fama himself. Shortly after publishing the Efficient Market Hypothesis, Fama, along with Kenneth French, showed that his original hypothesis contained major flaws. In fact, as has been repeatedly proven over the ensuing 30-plus years, the market offers opportunities to increase expected returns while lowering volatility, all while producing more predictable income.

More to the point, overwhelming evidence demonstrates that value stocks have consistently earned substantially higher returns, experienced less volatility and generated more income than more traditional approaches.

This superior performance in value stocks is significant. Using the Fama-French performance numbers, investing in small cap value stocks instead of small cap growth stocks would have nearly doubled annual returns over the past 80 years, resulting in a 10,000 percent return. Over the same 80 years, large cap value stocks earned nearly 3 percent more per year than large cap growth stocks, resulting in a 700 percent return. Both categories of value stocks also experienced less volatility than either category of growth stocks, largely due to their substantially higher dividend yields.

In addition to working well over long-and short-term periods, value-based strategies excelled during the supposed growth decades of the 1980s and 1990s, and a number of common indices show value stocks earned substantially higher returns and enjoyed lower volatility.

It's not surprising that most investors are unaware of this major market aberration given the average individual's low level of general market knowledge. However, what is amazing is how few advisors understand the opportunity or seek to profit from a well-documented phenomenon.

If you act independently with intelligence and courage by employing value-focused strategies, it's very likely you and your client will be richly rewarded. While past performance never guarantees future results, the value premium is largely a result of human nature and therefore is unlikely to change significantly.

Anyone who lived through the recent market downturn should appreciate an equity strategy that provides superior returns while limiting losses during inevitable market fluctuations. The combination also generates greater client loyalty -- after all, who isn't looking for an advisor who can increase returns and reduce volatility?

Finally, higher returns, lower volatility and increased income are a perfect combination for investors who are approaching or already enjoying retirement. Portfolios can be designed to provide tax-advantaged income of more than 4 percent, and dependable dividend income can facilitate intelligent withdrawal or spend-down strategies.

At our money management firm, we've had great success employing strategies steeped in value-based logic using both individual stocks and ETFs. Clients love the results, and we love the ensuing client loyalty.

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