Wouldn’t it be great if we were all in perfect shape and successful? I would argue no. At least we wouldn’t think it was great. The reason, I believe, that we value these attributes is scarcity. If everyone had a perfect body and was accomplished, it would be no big deal. It would be common and, as a result, its value would disappear.
While these end results are desirable, the effort to achieve these goals also commands respect. A good physique is the outcome, but it requires hours of effort and discipline to attain. Similarly, success – be it professional or personal – comes only after pouring time and energy into an effort. The same can be said of investing in the equity markets. Why do some investors stand out? The end result (higher returns) and effort (discipline) sets them apart. Higher returns can be sought through active management (stock picking and market timing); but, studies show that the higher costs that come along with this approach lead to sub-par results. Holding a concentrated portfolio of a few stocks may lead to outsized gains, but it may also leave you penniless.
Based on the above, one could argue for an indexing approach. Indexing avoids the losing bet of active management and diversifies a portfolio. Additionally, it keeps costs low. However, it has flaws. The return achieved will closely track the gain/loss on a benchmark. This benchmark, which is maintained by a third-party, defines the investment strategy. The strategy is not necessarily based on fundamentals, but on index rules. The focus of replicating the benchmark can lead to forced transactions and costs. Lastly, the changes that the index must make can distort prices of securities being added or removed.
Dimensional Fund Advisors (DFA) engages in asset class investing. This approach retains the benefits of indexing (low turnover, diversification, low costs). But, unlike indexing, the return sought is that of the asset class, not a commercial benchmark, and investment decisions are based on the return dimensions of stocks, not index rules. This technique means increased flexibility on transaction timing and better management of trading costs. Also, by avoiding securities that are part of an index change, mispriced securities can be evaded.
On top of these operational efficiencies, DFA targets factors (low valuation, small company size, and higher profitability) that have historically provided higher returns. But, these higher returns are not free. Return and risk are directly related – to achieve higher returns, higher risk must be borne. And, like fitness and success, if it was easy to achieve higher returns, everyone would follow the approach and achieve the better result.
Just as there are days that you may not want to go to the gym or spend another hour working on a task, there will be times in asset class investing where you’ll want to throw in the towel. Higher risk leads to the possibility of short-term underperformance. But, those who have the discipline to persevere and focus on the long-term goal will be rewarded with an outcome that is rare and desirable.
Dan is responsible for developing investment strategy and managing client portfolios for Trust Company. Prior to joining the firm in 2008, Dan was a vice president at Smith Breeden Associates in Chapel Hill. His focus was on performance measurement and, earlier, he performed analyses for the firm’s Financial Institutions Consulting Group. His career began as a financial analyst in the Business Process Outsourcing (BPO) unit of PriceWaterhouseCoopers.