As the new year begins, one of the most common questions I’m asked in my role at the firm is, “What do you think about 2016? Was it a good year?” In this context, the question typically refers to the year from an investing perspective. However, assigning a letter grade or a broad ranking to the span of a year doesn’t necessarily align with the depth of our experience and how the world’s events impact our lives. Categorizing a year as exclusively good or bad can overlook the complexity of events and interactions that occur within a 12-month window that include some of the best moments we’ve ever experienced, as well as others we’d rather forget—even if we limit that simply to our experience as investors. In that context, however, in measuring overall success for disciplined investors in 2016, it was in fact a very strong year.

It’s with the perspective of reflecting on the events over the past year and the experiences investors had, both positive and negative, that we are able to celebrate the results.

The S&P 500 Index, as one measurement, was up nearly 12%. In fact, many countries posted returns well into the double digits—bolstering most investors’ portfolios and retirement savings. Despite significantly rising interest rates over the second half of the year, bond returns, while not strong, were positive for 2016. Even broadly measured commodity indexes chugged upward after many years of sub-par performance.

With all of this good news, what else do we need in order to evaluate the year?

In conducting an annual review by simply measuring a starting and ending value of an investment portfolio, we may tend to overlook what occurred between the beginning of the time frame and the end results. Upon reflection, you can recall that the past year afforded many opportunities for investors to throw their hands up and say ‘enough!’ and, in doing so, lose focus on their long- term financial well-being. Stocks not only started the year off in the red—they actually had the worst start in history. After recovering from early year lows, global markets were rattled again when the citizens of the United Kingdom voted to leave the European Union (BREXIT), a very unexpected outcome. A few months later, the U.S. had its own election surprise with Donald Trump winning the Presidential race—unexpectedly boosting U.S. stock returns and deflating bond values.

It’s with the perspective of reflecting on the events over the past year and the experiences investors had, both positive and negative, that we are able to celebrate the results. Discipline is rewarded, but only when combined with patience and tolerance for volatility.

Focusing more deeply on 2016 equity returns, the performance of small and value stocks significantly outperformed the broader stock market indexes. Companies that fall into these particular categories have consistently provided investors with higher returns over the long term. The strength of those returns in 2016 boded well for CCM clients, given our “tilts” to small and value stocks.

Factor-based investing is a framework we have integrated into our portfolio construction process for almost two decades, and is helpful to understand in the context of what occurred in 2016. In constructing portfolios with higher expected returns than risk-free treasury bills, the factors (such as small and value) that we use not only need to meet the quantitative measures of strong performance, but also have to pass through additional key analysis and important filters.

In order for given “factors” to be considered in CCM portfolios the following criteria must be met:

  1. Be sensible and have some understandable reason for being.
  2. Exist across many different time periods.
  3. Be present across a variety of markets.
  4. Stand up to alternative specifications or definitions.
  5. Be able to be captured in a cost-effective manner within well-diversified portfolios.

When we build portfolios that focus on factors that have been vetted through rigorous academic inquiry like the market premium (stocks versus bonds), small cap premium (small stocks versus large stocks), or the value premium (value versus growth), we know that these approaches have been thoroughly run through the criteria listed above. In other words, we can have a high degree of confidence in the benefit of focusing on these factors.

  • That is, these dimensions of returns make sense to exist and persist as a higher reward for a) taking on risk and for b) controlling natural behavioral biases.
  • We see these premiums present in long, short and varied time period.
  • We know that these premiums are found in domestic and international markets—both developed countries to emerging.
  • We can define and measure these factors in different ways and get similar results.
  • And, we’re able to build low cost, tax-efficient, and well diversified portfolios that take advantage of what is widely understood.

With this context, hopefully you have greater insight not only into how factor-based investing is utilized at CCM, but the role it played in 2016 to help make it a “good” year.

For additional reading on factor-based investing, I recommend “Your Complete Guide to Factor-Based Investing,” by Larry Swedroe & Andrew Berkin.

NOTE: The information provided in this article is intended for clients of Carlson Capital Management. We recommend that individuals consult with a professional adviser familiar with their particular situation for advice concerning specific investment, accounting, tax, and legal matters before taking any action.