There are other good reasons to approach the topic carefully. Market efficiency and its offspring, passive investing, are counterintuitive for many investors. It is human nature to believe that one can beat the market (or identify someone who can) through intelligence, insight, and hard work. This belief is constantly reinforced by Wall Street and most of the mainstream media.

Even though some may characterize Dimensional’s approach as passive, it is only passive with respect to activities that don’t add value—mainly stock picking and market timing. One could argue that Dimensional is very active, however, in managing important considerations such as frictional costs and consistent exposure to targeted risks or asset classes.

Here are some examples of framing:

• We don’t speculate. We invest.Rather than relying on speculation, blind faith, or anecdotal evidence, our philosophy rests on a solid foundation of core principles from the science of investing.
• With capitalism there is always a positive expected return on capital.Capital markets are very competitive due to voluntary exchange between buyers and sellers. There is a buyer for every seller; for markets to clear, prices will adjust to new information and reach a level where there is always a positive expected return to providers of capital. Investors would not risk their capital without the expectation of a positive return. We invest in an approach that strives to capture a fair share of the capital market return based on the risk assumed.
• It is difficult to identify superior investment managers in advance.Capitalism breeds competition, and that makes markets difficult to beat. With millions of participants competing in capital markets, it is hard to identify in advance anyone who can systematically beat the market since past winners may have just been lucky and won’t necessarily win in the future. We eliminate the risk of choosing the wrong manager by following a broadly diversified approach that does not rely on stock picking or market timing.
• Diversification is the only antidote for uncertainty.Although diversification neither assures a profit nor guarantees against loss in a declining market, a properly constructed and well-diversified portfolio is a key component of a successful investment experience. We design portfolios that attempt to capture certain risks and eliminate others, depending on your preference and capacity for various types of risk.
• There is no free lunch. Risk and return are related.Higher expected returns only come from bearing more risk that cannot be diversified away. Much like a football player who chooses to play without a helmet, you should not expect to be paid more for taking risks that can easily be avoided. We focus on eliminating risks that you should not expect a reward for taking, such as concentrating your portfolio in just a few stocks.
• Control what you can.If speculation is futile, and trying to choose winners is more often a loser’s game, what can an investor do? The answer is to concentrate on what can be controlled: managing the transactional costs of investing, reducing the impact of taxes, and taking a long-term view. We implement portfolios in a way that is cost effective, tax efficient, and above all, disciplined.

Market efficiency and the active or passive decision are loaded with misconceptions that can lead to debate and confusion rather than constructive dialogue and understanding. More importantly, it can distract our attention from the most crucial element of all: discipline!

The studies comparing dollar-weighted returns to time-weighted returns are widely known, and behavioral research has documented the propensity for individual investors to skate to where the puck was (instead of where it is going). A decision to invest in an active, indexed, or Dimensional approach can often be differentiated in basis points, while percentage points often gauge the impact of an undisciplined or emotional decision unchecked by an advisor’s sound counsel.

This type of behavior is obviously hazardous to an investor’s wealth; therefore, we should attempt to determine if one of these alternative strategies has been able to mitigate some of these actions.

The charts below show the monthly cash flow into all equity funds (foreign and domestic) in the US , along with the prior twelve-month global equity market return. Cash flow bars that vary with, or more closely follow, the prior year return line could suggest more return chasing behavior among the investors within that universe of funds.

Source: ICI

Source: ICI Index is not available for direct investment; its performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results.

Source: Dimensional

A simple “eyeball” analysis of this anecdotal data suggests that investors in active mutual funds apparently were more influenced by short-term performance than those who held index funds, and advisors (and clients) who invested in Dimensional funds exhibited the most consistency.

The biggest difference between index funds and Dimensional relating to investor behavior may be the requirement for independent advice from a fee-only advisor. If part of the recipe for a successful investment experience is to stay the course, the advisor is the key ingredient to educating investors and keeping them disciplined through good times and bad.

The comments of Robert Dintzner are greatly appreciated.

Many thanks to Brad Barber for providing the ICI data.

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¹Dimensional cash flow data includes US, Canadian, UK, and Australian domiciled funds.

Dimensional Fund Advisors (“Dimensional”) is an investment adviser registered with the Securities and Exchange Commission.

This article contains the opinions of the author but not necessarily the opinions of Dimensional. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is provided for informational purposes only and should not be construed as an offer, solicitation, recommendation or endorsement of any of the products or services described in this website.

Let’s begin with some factual data and the word of some recognized authoritative experts.

First, Standard & Poors: “Over the five year market cycle from 2004 to 2008, S&P 500 outperformed 71.9% of actively managed large cap funds, S&P MidCap 400 outperformed 79.1% of mid cap funds and S&P SmallCap 600 outperformed 85.5% of small cap funds. These results are similar to that of the previous five year cycle from 1999 to 2003.”[1]

“After taking risk into account, do more managers than you’d see by chance outperform with persistence? Virtually every economist who studied this question answers with a resounding ‘no.’ Mike Jensen in the sixties and Mark Carhart in the nineties both conducted exhaustive studies of professional investors. They each conclude that in general a manager’s fee, and not his skill, plays the biggest role in performance.”

Eugene Fama, Jr.

“There are two kinds of investors, be they large or small: those who don’t know where the market is headed, and those who don’t know that they don’t know. Then again, there is a third type of investor – the investment professional, who indeed knows that he or she doesn’t know, but whose livelihood depends upon appearing to know.”

William Bernstein, The Intelligent Asset Allocator

“It turns out for all practical purposes there is no such thing as stock picking skill. It’s human nature to find patterns where there are none and to find skill where luck is a more likely explanation [particularly if you’re the lucky mutual fund manager]. Mutual fund manager performance does not persist and the return of stock picking is zero. We are looking at the proverbial bunch of chimpanzees throwing darts at the stock page. Their ‘success’ or ‘failure’ is a purely random affair.”

William Bernstein, The Intelligent Asset Allocator

“When some individual made a fortune in the stock market, we have a tendency to assume that was because he knew something, and of course the individual is happy to reinforce that belief – yes, I was a genius or I was very clever or I always said Microsoft was going to make me rich. But what you don’t see are the thousands, hundreds of thousands, perhaps millions of people who are going, ‘I always said that ABC Company was going to make me rich, and ABC Company went bust.’”

Professor Zvi Bodie, Boston University

“…skepticism about past returns is crucial. The truth is, as much as you may wish you could know which funds will be hot, you can’t – and neither can the legions of advisers and publications that claim they can. That’s why building a portfolio around index funds isn’t really settling for average.  It’s just refusing to believe in magic.”

Bethany McLean, Fortune

“Economic evidence shows that, from a typical investment perspective, the major capital markets of this country are highly efficient, in the sense that available information is rapidly digested and reflected in the market prices of securities. As a result, fiduciaries and other investors are confronted with potent evidence that the application of expertise, investigation, and diligence in efforts to “beat the market” in these publicly traded securities ordinarily promises little or no payoff, or even a negative payoff after taking account of research and transaction costs. Empirical research supporting the theory of efficient markets reveals that in such markets skilled professionals have rarely been able to identify under-priced securities (that is, to outguess the market with respect to future return) with any regularity. In fact, evidence shows that there is little correlation between fund managers’ earlier successes and their ability to produce above-market returns in subsequent periods.”

Restatement of Trusts [Third] §227 General Note on Comments e through h:
Introduction to Portfolio Theory and Other Investment Concepts

From current data, from academics, from journalists and from legal scholars, it is concluded that money managers cannot, with consistency, outperform the market. In another article we will discuss what one should do about this stubborn fact.

Click here to view the interview of Fama on Market Efficiency in a Volatile Market

Now that it appears that markets have reached a turning point, practitioners of the ‘dark art’ of predicting and exploiting investment trends by analyzing charts have been getting some favorable reviews.

These Technical Analysts, like the ones heard weekly on the business TV shows, use a bewildering range of tools and concepts to prophesy prices — from simple support and resistance points to daily volumes, moving averages, trend lines, oscillators and volatility.

Their esoteric approach to forecasting contrasts with that of fundamental analysis, that focuses on factors like company earnings, management, strategy, industry backdrop and the general economic environment.

One recent article in The Times of London heaped praise on technical analysts, saying they had done a much better job than fundamental analysts in charting the course of markets through the financial crisis.

Specifically, what has excited observers in the media has been a break by the S&P 500 through a “neckline” of a reverse head and shoulders formation. This, according to the chartists, is a very bullish signal.

If such indicators as head and shoulders patterns really are so reliable, as The Times¹ says, why would anyone trade against them?

Secondly, not all technical analysts agree. For every chartist who points to a bullish break on a head and shoulders formation, for instance, there may be another pointing to a bearish ‘Elliott Wave’ pattern or something like it. This contradictory condition is constant and should indicate the inadequacy of technical analysis, not support for it.

Of course, there is no way of knowing which of these techniques has got it right until after the fact, which is too late for us regular folks who want to profit from our activities in the markets. But in the meantime, it can be very diverting to look at the pretty pictures they draw. This is more of what I call “investment pornography.”

Taking a less cynical view, there is an honourable intention in technical analysis in attempting to separate the fundamental noise in pricing from the underlying signal. Many of these analysts believe in “mean reversion” — the tendency for prices to revert to their long-term average levels.

Technical Analysts also rightly understand that market dynamics themselves — shifts in daily trading volumes for instance — can be important influences on prices.

But this still leaves open the question about whether such methods can reliably predict turning points. If they did (now think about this a minute) everyone would be using them.

And while changes in security prices reflect both permanent (or fundamental) and temporary (or technical) influences, it is impossible to discern, before the event, the degree to which these varying influences will affect prices. So, how can one consistently profit from this information? One cannot.

A third observation is that most technical analysis — apart from Elliott Wave theory – is concerned with relatively short-term movements in prices. To the extent that these signals are any good, they really are only relevant to day traders whose business it is to profit from noise.

Long-term investors, by contrast, will be concerned with very long-term trends in prices and will focus on consistently capturing those risks that the historical record shows carry a reliable reward. Capital Markets U.com Magazine is interested in helping these long-term investors, not speculators.

These long-term investors will also ensure that those who manage their money are cognisant of – and are able to exploit – temporary and technical factors in the market that can affect prices.

A prudent approach to investing is one that is not dependent on forecasting — either via charts or fundamentals — yet recognizes the short-term frictions in the market that can cost investors dearly.

And you don’t even have to be a tea drinker to benefit.

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¹ Anatole Kaletsky, ‘The Fortunes of the Markets are in the Charts’, The Times, July 27, 2009

For some, a good part of this discussion may be over your head. For others, light bulbs may suddenly light up. In any case, this is a very interesting presentation for people who are interested in investor education. Enjoy viewing this video at the Fama/French Forum.

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“Investor Education for Main Street America”