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By Selwyn Gerber:

“Rip Van Winkle (is the) style of investing that we favor. Our stay-put behavior reflects our view that the stock market serves as a relocation center at which money is moved from the active to the patient. The much maligned idle rich have received a bad rap: They have maintained or increased their wealth while many of the energetic rich have seen their fortunes disappear.”
- Warren Buffett

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Chapter 8: BEYOND TRADITIONAL INDEXES:

Equal-weighted and fundamental indexes ® have distinct advantages over traditional capitalization weighted indexes. ETFs based upon these simple strategies can keep investors out of fad stocks and achieve steadier returns over time.

“While much has changed over the years, some things remain the same. There is still a strong relation between risk and expected return, and price scaled fundamental variables (such as book-to-market) still have explanatory power for stock returns. Some things have stood the test of time.”
- James L. Davis, Digging the Panama Canal

Research has consistently demonstrated that markets work. Markets around the world have a proven history of rewarding investors for their investments. The problem is that most individuals compete with each other to find the most attractive returns, trying to select the companies that will offer the best returns within a market. This competition between investors ensures that prices will remain fairly close to their fair value, meaning that no individual investor should expect greater returns than average without taking on greater than average risk.

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Active investment managers are all attempting to outperform the market by finding stocks they believe are mispriced by their peers. In other words, they are trying to predict the future by guessing which stocks will go up more than the overall market. The majority of the time, this proves costly and futile. Predictions are usually wrong, and these errors cause the active managers to miss the strong returns that markets provide since they are caught holding the wrong stocks at the wrong time.

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The simple fact that successful short-term speculation has been shown to be nearly impossible is actually good news for the long-term investor. It means that the market prices for stocks are fair and that differences in total returns can be explained by differences in risk. This leads us to the conclusion that it is certainly possible to outperform the market, but only by accepting increased risk.

Evidence from academic studies points to one inescapable conclusion: Returns are tied to risk. This applies in the markets just as it does in every other aspect of life. Gains are rarely, if ever, accomplished without taking a chance. Numerous studies into the markets can provide us with insight into what financial risks are worth taking and which ones are not.

In general, the studies conclude that two factors can be employed to consistently achieve above market returns. Small company stocks have higher expected returns than large company stocks and value stocks have higher expected returns than growth stocks. Many analysts believe small cap and value stocks outperform because they have greater underlying risks. Small companies are more likely to go out of business than large companies, for example, and value stocks may be low-priced because they have fallen on hard times and may not recover. The lower prices offer investors greater upside rewards as their compensation for taking on the risk.

Risk is rewarded over time. Over the long term, small cap stocks have outperformed large cap stocks by an average of more than two percentage points a year. The result is shown in Figure 8-1. A $10,000 investment in small caps would have returned an average of 12.7% a year and grown to more than $168 million over the eighty years ending in 2006. That same $10,000 in large caps would have grown to over $30 million, an average annual return of 10.4% per year.