Our investment philosophy is based on the academic research of Nobel laureates, evidence from market history and scores of empirical studies done over the last fifty years that comprise Modern Portfolio Theory.
The Basics of Modern Portfolio Theory:
“Markets are Efficient”
Markets work and, for investment purposes, assets are fairly priced.
It is our belief based on research and experience that capital markets are “efficient,” in that security prices reflect all available information and adjust instantly to any new information. Though prices are not always correct, markets are so competitive that it is unlikely that any individual can consistently profit in excess of all other investors. Thus, we do not expend valuable resources trying to out-guess the market or pick a handful of hopeful stocks.
We focus on strategies substantiated by Modern Portfolio Theory and backed by academic research.
Many studies have examined the performance of stock pickers and market timers as a whole and suggest that net of all expenses, beating the market is an unlikely prospect. Furthermore, our experience with the traditional form of “active management” is that it is often guided by the laws of chance, dictated by human emotions, bias and speculations. In contrast, our investment approach is an evidenced based one guided by academic research and the science of investing.
This 2-1/2 minute video explains how security prices are set—and change—based on the collective knowledge of buyers and sellers. Armed with this information, investors can be more confident about the power of the financial markets.
“Risk and Return are Related”
Priced risk factors determine expected return – the greater the return expectation, the higher the risk; lowering risk will lower expected returns.
Most of us would agree, based on past evidence, that over a long period of time it is reasonable to expect higher returns from stocks than from bonds. This pattern should hold true in the future because investors demand a higher return from stocks due to the increased risk stocks present over bonds. Less commonly discussed is that studies have demonstrated within equities (stocks), returns are best explained by company size (small companies have higher expected returns than large companies) and price characteristics (low priced “value” stocks have higher expected returns than higher-priced “growth” stocks). Small companies and value companies afford higher long-term returns because they carry more risk.
These fundamental principals are pervasive among the world’s capital markets. In other words, they apply not only to domestic equities but also within international markets and emerging markets. We use this concept to construct our client portfolios in such a way as to target the desired return while balancing the risk. It is our goal to eliminate unsystematic risk (risk that can be eliminated from a portfolio through diversification) from our client portfolios and focus on attaining a reasonable return for your risk profile over the long term. Past performance is not a guarantee of future performance.
“Diversification is Key”
Diversification is the antidote to uncertainty. Concentrated investments add risk with no additional expected return.
Empirical data supports Modern Portfolio Theory which states that assets should be selected on the basis of how they interact with one another, rather than how they perform in isolation. In this way, an investor can hope to achieve the highest possible return for the amount of risk taken. Capital markets are composed of many classes of securities, including stocks and bonds, both domestic and international. A group of securities with shared economic traits is commonly referred to as an asset class. There are several asset classes, all with average price movements that are distinct from one another. Investors can benefit by combining the different asset classes in a structured portfolio.
“Structure Explains Performance”
Asset allocation primarily determines results in a broadly diversified portfolio. The type of asset class funds and the percentage allocated to each one will have a major impact on risk and return.
Based on that evaluation, and our ongoing analyses, Dorman Skorheim Wealth Management uses and recommends the use of passively managed structured asset class portfolios. We rely heavily on the research produced by Eugene Fama of the University of Chicago and Kenneth French of Dartmouth College, two leading financial economists. Their analysis of the sources of investment returns has reshaped portfolio theory and greatly improved the understanding of the factors that drive equity performance. They have determined that there are three factors that influence returns, which include:
- Equity Market — (complete value-weighted capitalization) Stocks have higher expected returns than fixed income.
- Company Size — (measured by market capitalization) Small company stocks have higher expected returns than large company stocks.
- Value — (measured by ratio of company book value to market equity) Value stocks have higher expected returned that growth stocks.
The notion that equities behave differently from fixed income is widely accepted. Within equities, Fama and French find that differences in stock returns are best explained by company size and value characteristics. Taken together, the three factors on average explain more than 90% of the performance of diversified stock portfolios.