The 5 Factors That Actually Drive Your Investment Returns

When professional baseball scouts evaluate a hot new prospect, they use a five-point checklist: speed, throwing arm, fielding, batting for average, and hitting for power. These five skills are a remarkably accurate predictor of a player's future success in the major leagues.

It turns out that the world of finance has a similar model. Financial economists have pinpointed five key factors that explain the vast majority of expected returns you'll see from a well-diversified portfolio. Three of these relate to stocks, and two relate to bonds, or fixed-income assets. Understanding these five factors is fundamental to grasping at its core. By looking at a portfolio through this lens, we can get a much clearer picture of its expected performance.

The Three Factors That Drive Stock Returns

One of the biggest lessons for anyone is that long-term returns from stocks have very little to do with being a genius stock picker or perfectly timing the market. Instead, your results are overwhelmingly determined by your portfolio's exposure to three specific risk factors.

Think of "returns" here as the premium you earn above the risk-free rate you'd get from a one-month U.S. Treasury bill.

1. : This is the most basic one. Simply being in the stock market carries risk compared to safer assets like bonds. Because you're taking on that risk, you expect a higher return. Historically, from 1927 through 2003, this "equity risk premium" has been just over 8% annually. (Due to volatility, this averages out to a compound return of about 6%). All involves exposure to this general market risk.
2. : It's intuitive that smaller companies are riskier than massive, established corporations. To compensate for that extra risk, smaller companies have historically delivered an additional annual premium of just over 3% (about 2.5% after accounting for volatility) compared to large companies.
3. : Some stocks are considered "value" stocks (high book-to-market ratio), while others are "growth" stocks (low book-to-market ratio). Value stocks are seen as inherently riskier, and because of this, they've offered an annual risk premium of a little over 4% (or 3.5% after volatility) above what growth stocks provided.

These premiums aren't just a U.S. phenomenon; studies have confirmed their existence in international and even emerging markets. Every stock portfolio, whether it's an S&P 500 index fund or a mutual fund, has a certain "loading," or exposure, to each of these three factors. For example, the S&P 500 is so heavily weighted toward large companies that its exposure to the size factor is actually negative (-0.14). A small-cap index like the Russell 2000, on the other hand, has a strong positive exposure to size (0.85).

The Two Factors for Fixed-Income Returns

When it comes to like bonds, the story is similar. Success isn't about predicting what the Federal Reserve will do with interest rates. The returns from a fixed-income portfolio are determined by two main risk factors. The central question for bond investors is the same as for stock investors: how much risk are you willing to take for a potentially higher return?

1. : This is the risk associated with the length of a bond. A 30-year bond is more sensitive to interest rate changes than a 2-year bond. For taking on this longer-term risk, investors have historically received a premium of about 1.6%.
2. : This is the risk that the issuer of the bond won't be able to pay you back. Interestingly, for investment-grade corporate bonds, the extra yield they offer compared to ultra-safe U.S. government bonds has historically been wiped out by credit losses, higher management expenses, and features like "call options," which allow the issuer to repay the bond early if interest rates fall.

How to Estimate Your Future Returns

A common mistake is simply assuming historical returns will repeat themselves. The price you pay to invest matters enormously. A better approach, especially if you're figuring out , is to use current data to form realistic expectations.

For stocks, a method called the Gordon model suggests that your expected real (after inflation) return is the current dividend yield plus the estimated real growth of the economy. For example, if the current dividend yield is 2% and we conservatively estimate real economic growth at 2%, the expected real return for the total stock market is 4%—quite a bit lower than the historical average.

You can then add the risk premiums for specific asset classes:

• Small-Cap Stocks: 1%
• Small-Cap Value Stocks: 4%
• (REITs): 1%

For bonds, the best predictor of future returns is simply today's yield curve. If a 10-year Treasury bond yields 4%, that's your best estimate for its future return.

By combining these factors, you can build a picture of your portfolio's potential. A simple portfolio of 50% large-cap stocks (with an estimated 6% nominal return) and 50% small-cap value stocks (10% nominal return) would have a weighted average expected return of 8%. Just remember, this is a median estimate, not a guarantee. You're effectively planning for a 50/50 chance of hitting your goal, which is why understanding risk is so important when .

The Real Way to "Beat the Market"

Now that you understand these factors, you can see that "beating the market"—if you define the market as the S&P 500—isn't that hard. All you have to do is build a portfolio with higher exposure to the size and value factors. You'll be taking on more risk, but you can expect to be compensated with higher returns over time.

This is why judging an active fund manager against the S&P 500 is often an apples-to-oranges comparison. A small-cap value manager beat the S&P 500 over the long run because they are taking on more compensated risk. The real test is whether they can beat a passive index fund that tracks the same small-cap value asset class. When you make that fair comparison, the data shows that most active managers fail.

This framework of five factors is the foundation of a disciplined strategy. It shifts the focus from chasing hot stocks to thoughtfully deciding how much exposure you want to the proven, long-term drivers of return.