Why I Like Evidence-Based Investing
Why I Like Evidence-Based Investing
Most investors don’t want to be bothered with the details of investing, and I don’t blame them. I don’t want to know all the details of the drugs my doctor prescribes. But I do want to be a good steward of my health by selecting a doctor I can trust and knowing why procedures are done. That is why I became a fee-only advisor; I wanted to be able to put the client’s mind at ease so they could focus on other things. Using evidence-based investing is a part of that client-first model.
So what is evidence-based investing?
Evidence-based investing (sometimes called rules-based or research-based) doesn’t try to match an arbitrary “market” index, nor does it try to actively pick stocks to beat the market. It does however make it possible to identify factors that can be exploited and provide market-beating returns over the long-term.
Characteristics of most evidence-based investing:
1) Low-Cost
· The main purpose for investing is usually to grow assets and build wealth in a risk-adjusted way for a future goal, like retirement or college.
o This can’t be done if fees eat up returns.
o In my experience the high fees also seem to go along with non-transparent non-client friendly assets.
2) Diversified
· Because this type of investing is not trying to stock pick, most of these funds own most or all of the market but then tilt or weigh parts of the market differently based on expected returns.
· Because you don’t know exactly when or which stocks will outperform, you must always be exposed to the proven factors of outperformance.
3) Facts back it up
· Most active investment managers don’t operate based on decades of research or data. Instead they operate based on the premise that a single or handful of managers know more about a specific company than the collective market.
In my view Dimensional Funds was the first firm to discover evidence-based investing and they continue to execute it the best.
For Dimensional, the main lessons of the theoretical and empirical research conducted over the past few decades are:
(1) There are multiple dimensions of expected returns, and therefore, multifactor asset pricing models are needed to explain differences in the cross-section of average returns.
(2) Four factors—the market, size, relative price, and expected profitability—capture much of the common variations in average stock returns in a way that is consistent with multifactor asset pricing models.
Research has also shown that actual returns related to these expected premiums are largely unpredictable, both in terms of when any dimension might outperform and which individual stocks will drive the performance.
For those reasons, the best way to invest is to structure portfolios along the different dimensions of expected returns and target those dimensions continuously. This approach maximizes the likelihood of capturing the expected premiums associated with each dimension.
It’s these solutions that combine continuous exposure to the dimensions of expected returns with a portfolio design that facilitate patient trading and low turnover to maximize an investor’s chance of capturing the higher expected returns predicted by financial theory.
Additional reasons why I like Dimensional Funds:
· Transparency
o No commissions, no kickbacks, no “special relationships”, no hidden fees, and no “marketing up” stocks and bonds from their inventory.
· Investors are not paying for advertising
o Investors pay for all the advertising that companies like MFS, American Funds, Schwab, Fidelity, and Vanguard do. Dimensional does not have this expense.
· Less cash on hand
o Because only approved advisors are allowed to use Dimensional’s funds, there is less short-term trading and as a result, there is less turnover and cash on hand.
· Leveraging the real world – others are forced to trade
o “Active” managers are required to trade based on time constraints, this can force them to trade at a less than optimum price (pay more or less than they should).
o “Passive” managers are required to trade based on an arbitrary known date (index rebalance date) regardless of price.
o When you are forced to do anything, you usually pay/receive a less than the optimum price.
o Dimensional takes advantage of this reality by being on the other side of the trade for those that have to trade.
· Taxes
o Dimensional Funds often have lower turnover; and as a result lower taxes than index funds since they are not forced to trade.
· Indexes are arbitrary
o The companies that create indexes do so with the goal of selling access to the index to other companies. This incentive may, or may not, be in the best interest of the investor.
Vanguard vs. Dimensional
The title of this section implies a combative relationship; it is and it isn’t. For many clients, they are better off in a Vanguard or Vanguard-type investment compared to active investments. As for clients who wish to move in and out of investments or use their Roth as an emergency fund, Vanguard is a great option. But for most long-term wealth building investments, Dimensional is the best.
My ten-year-old son loves woodworking. The choice of tools to get the job done is endless, much like mutual funds available to an investor. If he has an edge that needs rounding there are some tools that are better than others and some that are perfect for the task at hand. If your task is to “roll the dice” and get rich quick, you can take your chances with an active manager. If you are looking for a long-term investment, a Vanguard-type investment is your next best option. If you are looking for best tool for long-term wealth building then Dimensional Funds may be right for you.
