Welcome to episode 68 of the One for the Money podcast. This is part 2 of a 2-part series on novel investment strategies. In this episode, I’ll review a novel investment strategy called factor investing.
In the tips, tricks, and strategies portion, I will share a second tip regarding stock options this time regarding incentive stock options also known as ISOs.
In this episode...
- Investment Factors & Potential Higher Returns [1:15]
- Factor Investing - Passive vs Active [6:32]
- Incentive Stock Options [9:12]
Factor investing is a strategy that chooses investments based on certain attributes or factors that historically have had higher rates of return. The assumption is that these same attributes will continue in the future.
The First one is that historically, stocks have outperformed bonds. Since 1926 stocks returned between 8% – 10% whereas the bonds returned between 4% – 6%. If you invested $1 in 1926 and earned the bond average of 5% it would be $113 by 2023, but if that dollar earned the stock average of 9% return it would be $4269. That’s why for longer-term goals we invest in stocks because historically they give you more to spend in the future when things will cost more.
The second investment factor is that smaller companies tend to grow faster than larger companies. Amazon and Apple all started in a garage and look at them now. But if people only invest in the S&P500 which all of the large American companies then they will miss out on buying the Apples, Teslas, Nvidia, Microsofts when they were smaller. From 1927 through December 2023 small stocks outperformed large stocks, 55% of the time after one year, 59% of the time after 5 years, and 68% of the time after 10 years.
The third factor to consider while investing is the price of the stocks you are buying. Some stocks are more expensive than others. Confusingly, this has nothing to do with the price of the stock but rather the price of the stock relative to the earnings of the company. This is known as the P/E ratio. On average, value stocks have outperformed growth stocks by 4.4% annually in the US since 1927. From 1926 through December 2023 value stocks were higher than growth stocks, 59% of the time after one year, 70% of the time after 5 years, and 78% of the time after 10 years.
The final factor to consider is profitability. That may seem like a captain obvious type comment but factoring in companies with higher probability can make a significant difference for investors. From 1963 through December 2023 high profitability companies were higher than lower profitability companies, 67% of the time after one year, 82% of the time after 5 years, and 92% of the time after 10 years.
Successful investing really should target factors that generate higher expected returns. Looking at average annualized returns going back decades, small-cap stocks have beaten large caps, value has outperformed growth, and high-profitability stocks have outgained low-profitability stocks.
Unlike active investing or trend models, factor investing doesn’t use a crystal ball but instead is grounded in economic theory and backed by decades of empirical data. Of course, past performance is no guarantee of future results but investing based on science is way better than investing based on an active manager's hunch or predictions about the future.
Tips & Tricks
ISOs are usually issued by publicly traded companies or private companies planning to go public. My tip regarding ISOs is whether you should take a higher salary and fewer ISOs or a lower salary and more ISOs and it really comes down to how much risk can you afford. If you are in your 20s or early 30s it can make sense to take a lower salary so you can receive more ISOs because you can live with roommates and because you have time to invest later, if this company isn’t as successful as one had hoped it would be. This approach can also make sense if you are much older and are on track for retirement. But if you are older and not on track for retirement then you will really want to consider taking a higher salary and fewer ISOs or a different job altogether. There are too many people risking their retirement on the hope that their one company rockets higher.
References
Factor investing
Incentive Stock Options
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