Our investment philosophy is based on the relationship between risk and return. We believe that in order to create higher expected returns an investor has to take more risk. Further, we believe that an investor should only take risks that are expected to be sufficiently compensated. However, for these risks to produce the appropriate rewards an investor needs to have an effective asset allocation and rebalance strategy in order to have consistent exposure to the risk factors Stratus believes affect expected return.
Stratus’ philosophy is rooted in academic research, particularly that of Eugene Fama (the 2013 recipient of the Nobel Prize in Economics) and Kenneth French. Their June 1992 paper, The Cross-Section of Expected Stock Returns, concluded that over longer time periods there are three primary risk factors that affect the expected return (E(R)) of stocks: the E(R) of stocks is greater than the E(R) of bonds, the E(R) of small company stocks is greater than the E(R) of large company stocks and the E(R) of value company stocks is greater than the E(R) of growth company stocks.
Eugene Fama continued his research into risk factors that affect expected return by looking at the risk-to-expected-return tradeoff for bonds. Fama discovered that over longer time periods there are two primary risk factors that affect the expected return E(R) of bonds: bonds with longer maturities have higher E(R) than those with shorter maturities and bonds with lower credit qualities have higher E(R) than bonds with higher credit qualities. However, we believe that the reward for taking more risk in bonds is not as great as in stocks so an investor needs to make sure that the risks they are taking are being properly rewarded.
Stratus also incorporates our own proprietary research and market experience into our investment philosophy. Stratus believes that every investor’s time horizon is described by a pre-limit random process because an investor will not live forever and therefore cannot make investment decisions based on long-term analyses. This may complicate an investment strategy because while value stocks may return more than growth stocks over longer time horizons, there is no reason that in the short-term the reverse cannot be true. Further, Stratus believes asset prices travel random-dependent paths, which means that a stock price that increases over a 5 year time period is driven by a random process even if it appears predictable or driven by fundamentals. These two factors lead us to conclude that the pre-limit, random nature of market movements make it difficult to consistently pick winning assets and therefore an investor’s best strategy is steady, disciplined exposure to risk factors that create higher expected returns.