Rolling the Dice on Return PremiumsJanuary 5, 2016
Test your knowledge of probability: If I’m rolling two standard six-sided dice and you’re picking the outcome (the sum of the two dice, any number between 2 and 12), what number do you pick?
If you’ve taken statistics or played many dice games, your strategy is to pick 7 because 7 is the most likely outcome. There are actually six different ways to roll a 7: 1+6, 2+5, 3+4, 4+3, 5+2, 6+1. That’s more than any other number.
Now the wrinkle: Let’s assume this is my tenth roll and I have not yet rolled a 7. What number do you pick now? Yes, 7! And what if I have rolled 100 or even 1,000 times without a 7? What number do you pick for the next roll? Yes, again 7!
Seven is the most likely outcome and the logical number to pick, no matter the previous results. Unless you are a fortuneteller, any other number is pure speculation and not grounded in science.
For the last 25 years we’ve constructed portfolios using science and the knowledge of various return premiums available in the market. We rely heavily on the work of Nobel Laureates and academics to zero in on return premiums that can help us construct better portfolios. We still don’t fully understand what drives these premiums, but our expectation is that they will be positive over time.
Above are the annual returns for the premiums we recognize when constructing client portfolios. The premiums are ranked from highest to lowest each year. Even though we expect positive premiums every year — just like we expect to roll a 7 when rolling two dice — premiums can be negative. In fact, just like we can have consecutive dice rolls without a 7, we can have consecutive years with negative premiums, as was the case in 2000, 2001 and 2002 for the Market premium.
The premiums undulate from year to year and no premium is consistently ranked at the top or bottom of the chart. This is why it is wise to be invested in many different premiums, since when one is underperforming, another will be near the top. And because there is no way to accurately and consistently pick the winners and losers each year, it’s important to stay the course, especially in challenging times.
What we learn about investing from rolling dice: Even though outcomes are likely and expected, they don’t always happen. Regardless, we don’t abandon our strategy.
All investments involve risk, including the loss of principal and cannot be guaranteed against loss by a bank, custodian, or any other financial institution.
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