The Science of Investing

At Shearwater Capital, our core philosophy is to serve our clients by taking a scientific approach to capital markets. In other words, we derive strategies from the academic study of finance and apply them to the practical world of managing money.

A fundamental principle in financial economics is that investment returns come from risk. However, not all risks carry a reliable return. Unnecessary risks, such as holding too few securities or chasing the latest hot-performing asset class, are not rewarded in the long run. There are three significant risk factors that have been shown to correlate strongly with investment returns:

1. Stocks are riskier and have higher expected returns than bonds.
2. Small companies are riskier and have higher expected returns than large companies.
3. Value stocks are riskier and have higher expected returns than growth stocks.

As shown below, these effects have been well documented not only in US markets, but around the world:

Source: Dimension Fund Advisors

(Author's note: Standard deviation of returns is a commonly used measure of investment risk in academic finance.)

At Shearwater, we strive for higher returns by efficiently capturing the risk premiums of small cap and value stocks. However, there is always a potential downside associated with risk. In order to mitigate this downside, we construct well-balanced portfolios that are broadly diversified across a wide range of US and international asset classes. While we emphasize small cap and value stocks in our client portfolios, we do not exclude other asset classes such as large cap and growth stocks. This helps to smooth out the equity curve over time. For most clients, we also use fixed income securities to temper overall portfolio volatility.

While these measures help to dampen the volatility of investment returns, there is no way to eliminate risk. As an equity investor, you will inevitably go through periods when your portfolio declines in value. Successful investing requires some faith that capital markets will reward patient investors, as they always have. It takes discipline to stick with a sound investment plan through good markets and bad. Finally, a long-term outlook helps to put temporary market setbacks in proper perspective.

Please do not hesitate to contact me if you have any questions or comments.

Jeffrey J. Brown, MD MBA CFA
Shearwater Capital

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