Finance & Accounting Jun 7, 2018
Take 5: What’s in Your Investment Portfolio?
Here’s what our faculty have to say about assessing new stocks, investing in green companies—and the benefits of benign neglect.
Ever wondered whether your favorite investment tool actually works? Or what research has to say about the benefits of benignly neglecting your portfolio? Or why investors are looking closely at companies’ track records for sustainability?
In this collection of articles, our faculty discuss various aspects of investing. Read on—because an informed investor is a good investor.
The Capital Asset Pricing Model (CAPM) is the most commonly used tool for predicting stock returns for individual firms. Unfortunately, it doesn’t work, says Kellogg assistant professor of accounting information and management Matthew Lyle. Fortunately, he and his coauthor have come up with one that does.
The CAPM model focuses on how sensitive a stock price is to the broader market. “The biggest insight CAPM delivers is that the more exposure a stock has to market-wide upturns and downturns—the more the risk—the higher the expected stock return will be,” Lyle explains. However, after testing CAPM against data from the 1970s to 2013, the researchers found no evidence of its predictive powers.
The model they came up with uses accounting fundamentals instead: namely, a firm’s stock returns, its book-to-market ratio, and its return on equity. The researchers tested their model using the same data against which they had tested the CAPM model. They found that their new model—which they say is relatively easy for any investor to adopt—could robustly forecast stock returns up to three years into the future.
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How does Louis Simpson approach investing?
Called “one of the investment greats” by Warren Buffett, Simpson is former chief investment officer for Geico and current Chairman of SQ Advisors. He is also a senior fellow and adjunct professor of finance at Kellogg, a member of Northwestern University’s Board of Trustees, and a member of the Advisory Council of Kellogg’s Asset Management Practicum.
Simpson discusses his remarkably successful investment strategy in an interview with Robert Korajczyk, a professor of finance at Kellogg.
“You can only know so many companies,” says Simpson. “If you’re managing 50 or 100 positions, the chances that you can add value are much, much lower.”
Read the rest of the interview here.
Why put off till tomorrow what you can do today? Because, according to Kellogg finance professor Janice Eberly, you may get a better return on your investments that way.
Eberly and her colleagues have conducted research suggesting that investors who closely monitor their portfolios may be shooting themselves in the foot. That’s because the more you monitor your portfolio, the more likely you are to make changes to it—and, of course, there are costs associated with those changes.
So what does their research say about how often investors should check their portfolios? Even when costs represent only 0.01 percent of total wealth, the optimal inattention time is nearly eight months. As costs go up, that optimal inattention period does also.
Optimal inattention time is also affected by the rate of return on investment. For example, because less aggressive portfolios will de facto grow more slowly, they need to be optimized less often—whereas riskier portfolios with higher rates of return should be adjusted at more frequent intervals.
“I think of it as the optimality of procrastination,” Eberly says of her findings. “[S]ometimes nothing is actually the optimal thing to do.”
It’s not lucrative being green. At least, that is the perception of many investors, who cite lower share prices as a reason to avoid sinking money into environmentally sustainable companies. But are those investors correct in assuming that green firms perform poorly compared to others?
No, argues research from Kellogg finance professor Ravi Jagannathan and his colleagues. In fact, the researchers say, just the opposite is true: companies with sustainable practices can be a better bet.
Why? As the public becomes more concerned about environmental issues, more stringent environmental laws are likely to pass, and consumers will demand industry changes. These shifts will favor companies with higher ESG—environmental, social, and governance—ratings over those that overlook sustainability concerns.
Investors are taking note. A growing number of professional money managers are using companies’ ESG ratings to help identify promising firms to invest in.
Investors may want to focus on environmental metrics, says Jagannathan, because companies that aren’t prepared to weather change will “lose out in the long run.”
While some investors are choosing socially and environmentally responsible ventures for profit, others are equally interested in impact. As the field of impact investing expands, where can socially-minded investors identify opportunities?
Amit Bouri, CEO of the Global Impact Investing Network, points to tools like ImpactBase, which is a free, searchable online directory of impact-investment funds and products available to accredited investors.
“It started with about 30 impact-investment funds and products, and now has over 400,” says Bouri. “You can use this tool to get a sense of the opportunity that is out there.
“Many of the portfolio consulting firms that serve the large endowments, foundations, and pension plans are building significant databases of impact- and sustainable-investment funds,” adds David Chen, an adjunct professor of finance and program director of impact investing at Kellogg, and chairman of Equilibrium Capital Group.
“The comment ‘I couldn’t find these products’ may have been accurate three years ago—but today there’s no excuse,” says Chen.
Editor’s note: This information does not constitute investment advice, and should be used for informational purposes only.
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