Investing for 30 years of unemployment...called "retirement"

By Don Cox, CPA

Investing for one’s retirement is a rather daunting challenge. For most folks, investing during the retirement years is a time when capital preservation seems to be of paramount importance and becomes the driving force behind their asset allocation. The result often times is an allocation to fixed income or bonds that will not stand up to the devastating impact inflation is likely to have on their purchasing power over time. Perhaps the best illustration of what inflation can do to the cost of living is to look at the cost of a US Postal stamp 30 years ago relative to the cost of the same stamp today. 30 years ago you could buy a stamp and mail a letter for 18 cents. The same stamp today would cost 44 cents. Do the math and you will see that is a 144% increase. Because of this, preservation of purchasing power should be the driving force for asset allocation, not preservation of capital. This requires a greater allocation to equities as opposed to fixed income and bonds.

The problem with a larger allocation to equities is that historically the average investor has not fared well investing in the stock market relative to the performance of the market as a whole. Results of the Dalbar Study (DALBAR, INC QAIB 2010) which compares the overall return of all US Large Capital Mutual Funds with the actual average return of the individual investors in those funds are quite disturbing. The study has been updated each year for the previous 20 year period. While the universe of mutual funds mentioned above enjoyed annualized returns during the 20 year period of approximately 8.20%, the average investor in the funds only enjoyed annualized returns of approximately 3.17%. The reason for the difference is the average investor’s inclination is to enter the stock market during periods of great optimism (the stock market is moving higher), then sell out of the stock market when pessimism prevails (the stock market is moving lower). To say it another way, the average investor has a tendency to buy high and sell low.

Investors need to understand that the largest factor determining their success as an investor is not stock selection, market timing or other gimmicks the financial services industry may put forward, but their behavior. It is imperative that investors make a commitment to being invested in all markets, good and bad, while recognizing markets decline every several years. The key is not to allow yourself to act on fear when those market declines occur. We all know fear is a human emotion that should not rule our lives, especially when it comes to investing.

In summary, to preserve our standard of living through the approximately 30 years of unemployment, we call “retirement,” we should focus on preserving purchasing power and not just on capital preservation. By doing so, we find we likely need a larger allocation to equities.

With the average investor’s dismal track record of investing in the stock market, we thought it would be helpful to adopt a set of 10 New Year’s resolutions that may help you succeed where others fail. These resolutions were originally penned by Brad Steiman of Dimensional Fund Advisors.

1. I will not confuse entertainment with advice. I will acknowledge that the financial media is in the entertainment business and their message can compromise my long-term focus and discipline, leading me to make poor investment decisions. If necessary I will turn off CNBC and turn on ESPN.
   
   
2. I will stop searching for tomorrow's star money manager, as there are no gurus. Capitalism will be my guru because with capitalism there is a positive expected return on capital, and it is there for the taking. And for me to succeed, someone else doesn't have to fail.
   
   
3. I will not invest based on a forecast—whether it is mine or anyone else's. I will recognize that the urge to form an opinion will never go away, but I won't act on it because no one can repeatedly predict the future. It is, by definition, uncertain.
   
   
4. I will keep a long-term perspective and appropriately consider my investment horizon (i.e., how long my portfolio is to be invested) when determining my performance horizon (i.e., the time frame I use to evaluate results).
   
   
5. I will stick to my financial plan because it is time in the market—and not timing the market—that matters.
   
   
6. I will adhere to my plan and continue to rebalance (i.e., systematically buying more of what hasn't done well recently) and selling some of what has performed well.
   
   
7. I will not focus my portfolio in a few securities, or even a few asset classes, as diversification remains the closest thing to a free lunch.
   
   
8. I will ensure my portfolio is appropriate for my goals and objectives while only taking risks worth taking.
   
   
9. I will manage my emotions by learning about and acknowledging the biases and cognitive errors that influence my behavior.
   
   
10. I will keep my cost of investing reasonable.

The above article was published in the Kitsap Business Journal on March 3, 2011.

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Does Monetary Expansion Stoke Inflation?

Since the financial crisis hit in late 2008, the US monetary base has more than doubled, from about $800 billion in mid-2008 to about $2 trillion in November 2010.1 When the Federal Reserve announced a second round of quantitative easing (QE2), it raised investor concerns that such actions would stoke inflation.

The chart below shows that the US monetary base has spiked since 2009. While inflation has fluctuated considerably, it has not tracked the changes in the monetary base. Although no one can reliably forecast inflation, we think markets do a pretty good job of sorting through all the macroeconomic data. At present (mid December), the markets do not appear to reflect expectations of runaway inflation in the near future.2

US Monetary Policy since 2000

Source: Federal Reserve Board

Nevertheless, investors may be growing anxious in response to media coverage of the Fed’s continuing expansionary policy. For those who are certain QE2 will be inflationary, perhaps the recent example of Sweden’s monetary base run-up will offer some reassurance. 

In the 1990s, Sweden’s central bank, the Riksbank, more than doubled the country’s monetary base during the Nordic banking crisis, but inflation remained moderate during and after the expansionary period. The graph below documents that even as the monetary base jumped from 1994 to late 1996, inflation did not follow suit, and in fact, remained flat before falling in 1996.

Swedish Monetary Policy in the 1990s

Source: Sveriges Riksbank

Sweden’s monetary base expansion is one of several international examples of quantitative easing over the past two decades. These case studies, which include past expansionary periods in the UK, Switzerland, Japan, Australia, New Zealand, and Iceland, are discussed in a recent Federal Reserve Bank of St. Louis review.3 The researchers concluded that doubling or tripling a country’s monetary base does not lead to high inflation if the public views the increase as temporary and expects the central bank to maintain a low-inflation policy.

Of course, many factors may come into play, and we cannot know whether the US will share the same fortune. But at least we know that quantitative easing has occurred without triggering high inflation.

1. Monetary base is the total amount of the liquid currencies circulating in the hands of the public, deposits in financial institutions, and the deposits of the commercial banks in the central bank of the respective country.

2. One indicator of expected future inflation is the difference in rates between US Treasury bonds and Treasury Inflation Protected Securities (TIPS), also known as the TIPS spread. As of December 16, the 10-year zero-coupon TIPS spread was 2.35% (http://www.federalreserve.gov/econresdata/researchdata.htm). Consider, however, that the spread also includes an inflation risk premium, so the spread is not an exact measure of the market’s inflation expectations.

3. Richard G. Anderson, Charles S. Cascon, and Yang Liu, “Doubling Your Monetary Base and Surviving: Some International Experience,” Federal Reserve Bank of St. Louis Review 92, no. 6 (November/December 2010): 481-505.

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Managers versus Markets

Proponents of active management believe that skilled managers can outperform the financial markets through security selection, market timing, and other efforts based on prediction. While the promise of above-market returns is alluring, investors must face the reality that as a group, US-based active managers do not consistently deliver on this promise, according to research provided by Standard & Poor’s.

S&P Indices publishes a semi-annual scorecard that compares...

>>To read the full article, download the document.

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1st Quarter 2010 Newsletter

The 1st quarter of 2010 marked the 4th consecutive quarter of above average overall market returns...

>> To read the 1st quarter 2010 newsletter we sent to our clients, download the pdf.

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The Stock-Bond Decision

Choosing a basic stock-bond mix is an important first step in portfolio design. Although the decision may appear simple, it can have a profound impact on your wealth.

Portfolio theory explains the value of making a deliberate, strategic decision about the proportion of stocks versus bonds to hold in a portfolio. This decision has roots in the “separation theorem,” which was proposed by Nobel laureate James Tobin in the late 1950s.1 The separation theorem proposes that all investors face two important decisions: (1) deciding how much risk to take, and then (2) forming a portfolio of “risky” assets (equities) and “less risky” assets (fixed income) to achieve this risk exposure.

Your stock-bond decision implements this risk position.

The Rationale
The theorem proposes that all investors who are willing to take stock risk should begin with a diversified market portfolio. Each investor then can dial down total risk in the portfolio by adding fixed income to the mix. The greater the bond allocation relative to stocks, the less risky the portfolio and the lower the total expected return; the greater the stock allocation relative to bonds, the higher the portfolio’s expected return and risk.

Investors who want to take even more risk than the market can increase exposure through borrowing on margin and/or tilting the stock portfolio toward asset groups that offer higher expected returns for higher risk.

So, how does one confidently allocate between stocks and bonds? A common method is to evaluate model portfolios along the risk-return spectrum. A riskier portfolio holds 100% stocks, and the least volatile portfolio holds 100% bonds. Between these extremes lie standard stock-bond allocations, such as 80%-20%, 60%-40%, 40%-60%, and 20%-80%.2 Then you compare the average annualized return and volatility (standard deviation) of each model portfolio for different periods, such as one, three, five, ten, and twenty years. Volatility is one of several risk measures investors may want to consider. With this in mind, the analysis should feature average returns, as well as best- and worst-case returns for the various periods.

While this technique relies on historical performance that may not repeat in the future, and does not consider various investment costs, it may help you think about the risk-return tradeoff and visualize the range of potential outcomes based on the aggressiveness of your strategy.

Refining Your Stock Allocation
After establishing the basic stock-bond mix, investors turn their attention to refining the stock allocation, which is where the best opportunities to refine the risk-return tradeoff are found.  Investors who are comfortable with higher doses of equity risk can overweight or “tilt” their allocation toward riskier asset classes that have a history of offering average returns above the market. Research published by Eugene Fama and Kenneth French found that small cap stocks have had higher average returns than large cap stocks, and value stocks have had higher average returns than growth stocks. By holding a larger portion of small cap and value stocks in a portfolio, an investor increases the potential to earn higher returns for the additional risk taken.

The final step in refining the stock component is to diversify globally. By holding an array of equity asset classes across domestic and international markets, investors can reduce the impact of underperformance in a single market or region of the world. Although the markets may experience varying levels of return correlation, this diversification can further reduce volatility in a portfolio, which translates into higher compounded returns over time.

Fixed Income Strategies
Research shows that two risk factors—maturity and credit quality—account for most of the average return differences in diversified bond portfolios. Long-term bonds and lower-quality corporate bonds typically offer higher average yields to compensate investors for taking more risk. But keep in mind that these premiums are considerably lower than the market, size, and value premiums documented in the equity world.

Investors generally hold fixed income to either (1) reduce overall portfolio volatility, or (2) generate a reliable income stream. These objectives typically lead to different investment decisions. The first approach, volatility reduction, is an application of separation theorem (i.e., hold equities for higher return and use fixed income to temper portfolio volatility). Rather than increasing risk to maximize yield, these investors want to hold fixed income securities that are lower risk. Certain fixed income asset groups are better suited for this strategy.

With this in mind, some long-term investors may seek to earn higher expected returns by shifting risk to the equity side of their portfolio. With an eye to minimize maturity and credit risk, they hold short-term, high-quality debt instruments that have historically offered lower yields with much lower volatility.

The second purpose for holding bonds is to generate reliable cash flow. Income-oriented investors, including retirees, pension plans, and endowments, may not worry as much about short-term volatility in their bond portfolio. Their priority is to meet a specific funding obligation in the future. Consequently, they design a portfolio around bonds and accept more volatility in hope of earning higher yields, which they pursue by holding bonds with longer maturities and/or lower credit quality.

Whether investing for total long-term return or for income, a portfolio should be diversified across issues and global markets to avoid uncompensated risk from specific issuers and to capture differences in yield curves around the world.

Summary
The stock-bond decision drives a large part of your portfolio’s long-term performance. During portfolio design, evaluating different stock-bond combinations can help you visualize the risk-return tradeoff as you consider the range of potential outcomes over time. Once you determine a mix, it can guide more detailed choices of asset classes to hold in the portfolio. And as your appetite for risk shifts over time, you can revisit the mix to estimate how shifting your portfolio mix may impact your wealth accumulation goals in the future.

Endnotes

1 James Tobin, “Liquidity Preference as Behavior Towards Risk,” The Review of Economic Studies 25, no. 2 (February 1958): 65-86.

2 The basic stock component may be reflected by the S&P 500 Index, or preferably, by a broader market proxy, such as the CRSP 1-10 Index. The CRSP 1-10 Index is a market capitalization weighted index of all stocks listed on the NYSE, Amex, NASDAQ, and NYSE Arca exchanges. The S&P 500 Index offers a proxy of the large cap US equities market. The fixed income component may be represented by an index of short-term US government securities or government and corporate bonds.

The information presented above was prepared by Dimensional Fund Advisors, a non-affiliated third party.

Disclosures

Stock is the capital raised by a corporation through the issue of shares entitling holders to an ownership interest of the corporation. A bond is a loan that an investor makes to a corporation, government, federal agency, or other organization. Also known as debt or fixed income securities, most types of bonds pay interest based on a regular, predetermined coupon rate that is set when the bond is issued.

Although investors may form their expectations from the past, there is no assurance that future investment results will model historical performance.

Indexes are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results.

Stocks offer a higher potential return as compensation for bearing higher risk. However, this premium is not a certainty and investors should not expect to consistently receive higher returns from stocks. In fact, market history shows extended periods when stocks did not outperform bonds.

Diversification neither assures a profit nor guarantees against loss in a declining market.

A bond portfolio designed for income also carries significant risks, including default and term risk, call risk, and purchasing power (inflation) risk. Foreign securities also are exposed to currency movements.

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Managing Inflation Risk

As the capital markets have improved, more investors have shifted their concern from weathering the financial crisis to anticipating the inflationary effects of rising federal spending and debt. Many people are asking how they can prepare for potentially higher inflation. This article explores two basic ways to address inflation uncertainty and highlights asset groups that may prove useful.

As you consider strategies, remember the difference between expected and unexpected inflation. Asset prices already reflect the market’s expectations about future inflation, given all available information. Inflation may turn out to be worse than expected, and this risk of unexpected inflation is what some investors may want to manage.

Hedging vs. Total Return Strategies
Investors can prepare for unexpected inflation by following one of two basic strategies—hedging the immediate effects of inflation or earning a total return that outpaces inflation over time.

Hedging involves choosing assets whose value tends to rise with inflation. Although holding these assets may reduce the total return of a portfolio, the positive correlation with inflation can help an investor keep up with rising consumer prices, at least over the short term. (Correlation refers to the co-movement of asset returns. When two assets are positively correlated, their returns tend to move together; when negatively correlated, their returns are dissimilar.)

Candidates for hedging include retirees, fixed income investors, and others who would experience a diminished living standard during an inflationary period. These investors are willing to forfeit long-term growth potential for more immediate inflation protection.

In a total return strategy, an investor attempts to outpace inflation by holding assets that are expected to earn higher real (inflation-adjusted) returns. This investor is willing to give up short-term inflation protection for an opportunity to grow real wealth. Younger investors are typically well suited for this strategy because they have many years until retirement and expect their earnings to advance faster than the inflation rate. As they save and invest for the future, they can accept more risk through greater exposure to higher-return assets, such as stocks.

To insulate a portfolio from unexpected inflation risk, both strategies may employ some combination of stocks, short-term fixed income, and Treasury Inflation-Protected Securities (TIPS). Let’s consider each of these:

Stocks
Equity securities have provided a positive inflation-adjusted return over the long term. From 1926 through 2008, the total US stock market, as measured by the CRSP 1-10 Index, outpaced inflation by an average of 6.16% per year.1 To achieve this higher expected real return in stocks, however, an investor had to accept more risk, as measured by greater volatility in returns, and endure periods when stocks did not outpace inflation. As a result, stocks may be less effective for hedging short-term inflation and more suitable for investors who want to beat long-term inflation by earning a higher total return.

Some investors assume that high inflation leads to lower stock market performance, while low inflation fuels higher stock returns. In reality, inflation is just one of many factors driving stock performance. US market history since 1926 shows that nominal annual stock returns are unrelated to inflation.

Fixed Income (Bonds)
Higher inflation can hurt bondholders in two ways—through falling bond market values triggered by rising interest rates, and through erosion in the real value of interest payments and principal at maturity. This inflation exposure tends to impact the prices of long-term bonds more than those of short-term bonds, and investors can mitigate the effects of rising interest rates by holding shorter-term instruments.

Many types of investors may benefit from holding short-term bonds. When interest rates are climbing, a portfolio with shorter-term maturities enables an investor to more frequently roll over principal at a higher interest rate. This can help inflation-sensitive investors keep up with short-term inflation and enable total return investors to reduce portfolio volatility, which can lead to higher compounded returns and growth of real wealth.

Treasury Inflation-Protected Securities (TIPS)
Issued by the US government, TIPS are fixed income securities whose principal is adjusted to reflect changes in the Consumer Price Index (CPI). When the CPI rises, the principal increases, which results in higher interest payments. At maturity, an investor receives the greater of the inflation-adjusted or original principal. The inflation provision enables TIPS to preserve real purchasing power and hedge against unexpected inflation.

TIPS are generally a good short-term inflation hedge since principal is adjusted for changes in the CPI. They are also a good portfolio diversifier for some long-term investors due to their negative correlation with equities and relatively low correlation with most types of fixed income assets. TIPS were introduced in 1997, so these correlations are based on a relatively short sample period.

However, keep in mind that TIPS prices also have been affected by changes in real interest rates, so TIPS may not track inflation one-to-one in the short term or over longer periods of time. In fact, TIPS can lose market value if real interest rates increase.

Commodities
Commodity futures, as well as gold and oil, are perceived as effective inflation hedges because their returns are positively correlated with inflation. But commodities are more volatile than stocks, and their returns do not always rise with inflation because of this significant volatility. So adding these assets to a portfolio may increase real return volatility, which could offset the benefits of hedging.

Investors should also consider the economic argument against holding commodities. Unlike stocks, commodity futures do not generate earnings or create business value. They are essentially a speculative bet in which there is a winner and loser at the end of each trade. Moreover, a broad-based stock portfolio already has significant commodity exposure through ownership of companies involved in energy, mining, agriculture, natural resources, and refined products.

Summary
While the media have featured divergent opinions and theories about the effects of recent government actions on inflation, no one really knows how consumer prices will respond to the complex forces at work in the economy and markets. Investors should carefully review their financial circumstances and investment goals before making changes to their portfolio.

As you assess your exposure to a high-inflation scenario and form a strategy that reflects your financial goals and risk tolerance, consider that:

• Expected inflation is built into asset prices. In our view, markets efficiently integrate all known information into prices. Thus, current prices already reflect expectations of future inflation. Only unexpected news will affect the inflation outlook.
  
  
• Hedging unexpected inflation has a cost. Investments traditionally regarded as effective short-term inflation hedges have lower historical returns than stocks—and some have much higher volatility.
  
  Volatility matters. Evaluating assets solely on their ability to track inflation disregards the effect of volatility on returns and risk. Some assets that are positively correlated with inflation have large return variances, and adding these to a stock and bond portfolio may increase overall volatility.
  

Even with the prospect for higher inflation, investors who take a total return approach may be better served than those who choose assets based on correlation with the CPI. By choosing assets with higher expected long-term returns and maintaining broad diversification, investors can seek to grow real wealth and preserve the purchasing power of their dollars.

Endnotes

1 Real return calculation:  (1+CRSP 1-10 Index return)/(1 + US CPI)-1. The CRSP 1-10 Index is a market capitalization weighted index of all stocks listed on the NYSE, Amex, NASDAQ, and NYSE Arca stock exchanges. CRSP data provided by the Center for Research in Security Prices, University of Chicago.

The information presented above was prepared by Dimensional Fund Advisors, a non-affiliated third party.

Disclosures

Inflation is typically defined as the change in the non-seasonally adjusted, all-items Consumer Price Index (CPI) for all urban consumers. CPI data are available from the US Bureau of Labor Statistics.

Stock is the capital raised by a corporation through the issue of shares entitling holders to an ownership interest of the corporation. Treasury securities are negotiable debt issued by the United States Department of the Treasury. They are backed by the government’s full faith and credit and are exempt from state and local taxes.

CRSP is a non-profit center that also functions as a vendor of historical data. CRSP end-of-day historical data covers roughly 26,500 stocks, both active and inactive. OTC bulletin board stocks are not included.

The indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results, and there is always the risk that an investor may lose money.

Diversification neither assures a profit nor guarantees against loss in a declining market.

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2010 Roth IRA Conversions
Copyright © 2007 Money-Zine.com

Back in May of 2006 there was a pretty significant change to the tax laws involving converting a traditional IRA to a Roth IRA. In the year 2010 everyone can convert their traditional IRAs to a Roth IRA - and that's an opportunity that not everyone had in the past.

[This article tells] about the Roth IRA conversion rule change that goes into effect in 2010 [and] some of the strategies that individuals can use to take advantage of this change, starting today. ...

>link to full article

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Bear Markets Do Wonders for Retirement
Copyright © TheStreet.com
By Joe Mont
Tuesday, October 27, 2009

The six-month bear market that wiped out nearly half of Americans' retirement savings threatens to scare away the class of investor who has the most to gain from it: young people.

Mutual fund manager T. Rowe Price says in a study that those who began to systematically invest in equities in severe bear markets were "significantly better off 30 years later than investors who began in bull markets." ...

>link to full article

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DFA Funds Hard to Buy, Easy to Own
CNBC on MSN, June 4, 2002
Copyright 2002 Timothy Middleton. Reprinted with permission
By Timothy Middleton
CNBC on MSN
June 2002

Call Dimensional Fund Advisors the anti-Long Term Capital Management.

The latter is the professor-run hedge fund that imploded because the risks it was trying to avoid bit it in the backside. DFA, likewise run by a coven of finance professors, doesn't avoid risk—it relishes it.

And that's produced an excellent long-term performance record, which, alas, most individual investors can't take advantage of. DFA funds are sold only through fee-only financial planners—and then only when DFA agrees to accept their business.

"I can't stand their attitude!" grouses a planner whom DFA turned down. "They've got great funds, and a great discipline, lots of deep thinking, but they've got an attitude."
Before Harold Evensky, a well-known planner, was allowed to invest in DFA funds, he had to trek to seminars it sponsors at places such as the University of Chicago. "I remember way back when they told me you had to be approved that I was incensed," he says. "But it's not elitist criteria they're pushing; it's professional criteria."

Today, DFA funds account for as much as 40% of a typical client's equity portfolio at Evensky, Brown & Katz, headquartered in Coral Gables, Fla.

DFA is run on principles developed in the nation's graduate schools of business, notably that of Chicago. They include the "efficient markets" theory, a phrase coined by DFA's director of research. They embrace "modern portfolio theory." And they know frequent trading can be more costly to investors than a high expense ratio, so they refuse to deal with hyperactive investors.

Keeping you and me out makes DFA more economical to run, which boosts the returns of shareholders it is willing to accept.

Tapping Academia's Brain Power

DFA was spawned at Chicago's graduate school of business in the 1960s and '70s when new principles of money management were evolving. A breakthrough was the development of a massive database of market statistics made possible by the advent of computers. It remains the property of what became the Center for Research in Security Prices, or CRSP.

Rex Sinquefield, a 1972 graduate of the graduate school and a co-founder of DFA in 1981, once told the New York Times, "If I had to rank events, I would say this one (the original CRSP Master File) is probably slightly more significant than the creation of the universe."

If that sounds like Thurston Howell III speaking, you're on the right island. DFAers actually talk Locust Valley Lockjaw—the language of "Gilligan's Island's" Howell and that other "the third," Louis Winthorpe of the film "Trading Places."

"Mr. and Mrs. Johnson are just as concerned about investment outcome as a company like BellSouth is, but their portfolio is a lot smaller," lectures Eugene Fama Jr., son of the professor who coined the phrase efficient markets and a DFA vice president. "We don't have time to educate and coach these people."

The senior Fama, on the faculty of the University of Chicago, is director of research for DFA. His research concludes that equities perform better than bonds, small-cap stocks better than large, and value stocks better than growth. In each instance, it's because they are more risky.

Fama also described the efficient market as one in which all information is known and reflected in stock prices, so fundamental stock analysis is useless. This thesis also holds that day-to-day price movements are random, which makes technical analysis irrelevant. Passive investing is the only efficient strategy.

Modern portfolio theory describes how to construct an investment portfolio optimized to deliver the highest returns for the amount of risk the investor is willing to accept. DFA does this on a custom basis for institutional clients, and in a more generic way in its mutual funds.

The firm manages $40 billion in assets.

DFA has 30-plus portfolios, covering all the basic asset classes. Virtually all of DFA's small-company and value funds are among the top 25% of their Morningstar category, including a number of international funds, such as DFA Continental Small Company (DFSCX).

"We take a global view of everything," says the junior Fama. "We use academic research as a kind of back office. Our research staff is the universities of America."

DFA's board of directors sounds like a Who's Who of US financial research; it includes Kenneth French of Dartmouth (who was Fama's research partner), Roger Ibbotson of Yale (another database maven) and Myron Scholes, the Nobel laureate in economics who teaches at Stanford.

Strategizing Risk

DFA's brand of passive investing is not quite indexing. It eschews reliance on stock picking and market timing, which indexers also do, but it doesn't tie itself slavishly even to its own custom-produced indices.

"The best negotiating position is not having to buy anything—and that goes in every aspect of life," Fama instructs. Traditional index funds are forced to buy the stocks in the index in direct proportion to their weight in the benchmark. DFA only looks at about two-thirds of the stocks in its various style universes and then "allows weights to vary all over the place," he says.

DFA puts its money where the risk is. The Russell 2000 Index ($IUX), widely used as a proxy for small-cap stocks, puts less than 4% of its weight in the smallest 20% of US companies. DFA's CRSP 6-10 Index allots nearly 25% of its money to those micro-cap stocks—the riskiest, but also the most rewarding.

The securities it selects demonstrate, according to the firm's black box, the purest attributes of their asset class. For example, real estate investment trusts are an important component of most small-cap indices, but they have bondlike characteristics, and DFA ignores them. The firm believes, along with most finance professors, that asset allocation accounts for nine-tenths of total returns, and securities selection for only the remaining 10%.

Passivity Pays

The evidence bears out this powerful argument against active management. The average small-company mutual fund has returned an average of 12.2% in each of the last 10 years, according to Morningstar. DFA US Small Cap (DFSTX) has averaged 13.5%, and DFA US Micro Cap (DFSCX) has done even better, with annualized returns of 15.7%.

The 1.3% advantage Small Cap has over its average rival is, by no coincidence, little more than the difference between the fund's 0.56%1 expense ratio and the small-company average of 1.54%. The chief argument in favor of passive investing is that it is cheaper, and DFA's low-turnover approach makes it cheaper still.

"They have very low costs, so what you get is the return of the portfolio," says Diahann Lassus, a partner in Lassus, Wherley & Associates in New Providence, N.J., who also uses DFA funds for the core of client portfolios. "These funds are controlled by institutional investors like us. You don't have people moving in and out; hot money and market timers."

Of course, to enjoy these benefits, your money is nearly as much a captive as Gilligan was. You also have to meet Lassus's $6,300 minimum annual account fee, or the 1% of assets many other advisers charge.

But DFA's experience reinforces the argument advanced by two other low-cost fund providers, Vanguard Group and TIAA-CREF, that most people will do far better buying an index fund than hoping their manager is the next Warren Buffett.

Buffett has said he's lucky if he can find one good stock to buy every two years. The average actively managed equity mutual fund replaces its entire portfolio of more than 100 stocks every year. These trading costs, which are not included in a fund's expense ratio, make it that much harder for active managers to beat their benchmark. High ratios to support expensive research departments make it harder still.

You don't have to be a finance professor to figure out that DFA's approach gives you a head start in the race for returns.

At the time of publication, Timothy Middleton owned none of the securities mentioned in this article.

  1 The actual expense ratio for the DFA US Small Cap Portfolio is 0.42% as of November 30, 2001.

This article contains the opinions of the author(s) and those interviewed by the author(s) but not necessarily Dimensional Fund Advisors or DFA Securities LLC, and does not represent a recommendation of any particular security, strategy or investment product. The opinions of the author(s) are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed. This article is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale. Past performance is not indicative of future results and no representation is made that the stated results will be replicated.

Dimensional Fund Advisors is an investment advisor registered with the Securities and Exchange Commission. Consider the investment objectives, risks, and charges and expenses of the Dimensional funds carefully before investing. For this and other information about the Dimensional funds, please read the prospectus carefully before investing. Prospectuses are available by calling Dimensional Fund Advisors collect at (512) 306-7400; on the Internet at www.dimensional.com; or, by mail, DFA Securities LLC, c/o Dimensional Fund Advisors, Palisades West, 6300 Bee Cave Road, Building One, Austin, TX 78746.

Mutual funds distributed by DFA Securities LLC.

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Investment Advisers: What you need to know before choosing one.
U.S. Securities and Exchange Commission

The SEC receives many questions about investment advisers—what they are and how to go about choosing one. This document answers some of the typical questions we receive from investors about investment advisers. This Q&A is for the benefit of investors. You should not rely on it to determine if you need to register as an investment adviser. ...

>link to full article

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DFA in The Trade news
"Good things come to those who wait." John Romiza, head of international equity trading, Dimensional Fund Advisors, outlines the ‘patient and flexible’ trading approach that the US -based asset manager has exported to Europe and beyond.

John answers the question "From an investment and trading perspective, what makes Dimensional different from other asset managers"?...

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The Best Mutual Funds: DFA or Vanguard?
Written by Paul Merriman
The most important favor that long-term investors can do for themselves is to invest in the right kinds of assets, or asset classes. Examples of asset classes are stocks and bonds. More specific examples are U.S. large-cap value stocks, emerging markets stocks, high-yield bonds and short-term corporate bonds. ...

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