CONVENTIONAL INVESTING & INDEX INVESTING VS. EVIDENCE BASED INVESTING
Should you utilize actively managed funds (conventional investing) or use index funds (passive strategy)? This has been a debate for quite some time. For decades, conventional investing is all we knew. Indexes on the other hand weren’t supposed to be the investment. Indexes were designed to be the measurement for conventional investing. After the indexes were created, it was discovered that most of the professionally managed funds couldn’t beat the index. What we’ve learned through years of history and study is that only about 15% of the actively managed mutual funds available have beaten the indexes. So, as an investor if you knew you had an 85% chance of making less money than your designated index, what would you choose? Yes, 15% of those mutual funds did beat the index. The problem is you had no idea before hand what mutual fund was going to beat the index and how much risk they were going to take to do that.
From this explanation, you might say “Great. Thanks. I’ll go buy that index fund now”. And, you might be ok if you did that on your own. Chances are you would be better off if you bought the index fund and held onto it than if you had invested conventionally. However index funds have their own set of problems. These are problems you don’t hear advertised due to the massive amount of inflows into index funds right now. Plus, you have billionaire investor extraordinaire Warren Buffet telling you to buy index funds. A downside of utilizing index funds are the Hidden Costs. One of the hidden costs of owning an index fund is something called “Reconstitution day”. An index fund must follow an index or else it’s not an index. If a stock is no longer part of an index, what happens? The stock is moved out of the index. What happens when a stock is performing well and has increased in size? It moves into the index. The problem is this all happens on the same day. Everyone knows it’s coming. So, what happens? The stocks being sold decrease further in value and the stocks added to the index increase in value. By the time this happens, you have lost money on both ends.
There’s a third approach. This third approach was designed by noble prize winners from the University of Chicago and is implemented through Dimensional Fund Advisors. Unfortunately, the average investor can’t walk into Dimensional funds and use this approach. But, we will gladly help you incorporate this strategy! We believe this third approach is a better option. Actually, it’s been proven to be a better investment. Rather than trying to predict what’s going to happen in the market, we embrace the market pricing. We say, “You know, most of those guys on Wall Street are pretty smart and they have way more information than we do”. So deciding that most of the analysts have it right, we move to consider expected return. We know that not all stocks are going to have the same return. The same is true in the real estate market. The value of a Beverly Hills home is going to grow faster than homes in Cleveland. Even though you know the Beverly Hills home is going to appreciate faster, you might still want that Cleveland home because it’s also going to appreciate. We may not want to own every home in Cleveland, but we know we want some of them. Translate this to stocks and you have an idea of why we think certain stocks should and shouldn’t be in our portfolio. As fund managers at DFA pick these stocks they start to discern, “is the stock too expensive?”, “is it right for the portfolio?”, “can we get the stock cheaper tomorrow”? Then by eliminating stocks that are too expensive or have appreciated too much, a basket of stocks is created for clients to invest. In addition, it’s been proven over time that value stocks outperform growth stocks with less risk. Knowing this, portfolios are created with a tilt towards Value. A quick note: 82% of Dimensional Funds have beaten their index.
This is just one of the many reasons you should choose to work with our firm. We’d love to introduce you to evidence-based investing. Email me today to learn more about how this approach can help you with your goals.