Here’s a letter from Dimensional Chairman, David Booth, that extols the virtues of having a robust investment philosophy.
After more than 35 years in the financial services industry, I have found that having an investment philosophy—one that is robust and that you can stick with—cannot be overstated.
Just like a personal philosophy can act as a moral compass, an investment philosophy can guide your decisions on how to
invest. While this may sound simple, the implications can be significant. People who put their savings to work in capital markets do so with the expectation of earning a return on their investment, and there is ample evidence to support that long-term investors have been rewarded with such returns. But we also know that investors will encounter times when the results are disappointing. It is in these times that your philosophy will be tested, and being able to stay the course requires trust.
The alternative approach likely consists of moving between different strategies based on past results, which is unlikely to lead to a good outcome.
At Dimensional, our investment philosophy is based on the power of market prices and guided by theoretical and empirical research. What does that mean? Markets do an incredible job of incorporating information and aggregate expectations into security prices, so it does not make sense to form an investment strategy that attempts to outguess the market. Our approach focuses on using information contained in prices to identify differences in expected returns. We conduct research to help us organise our thinking, improve our understanding of what drives returns, and gain insights on how to build sensible portfolios. One such insight is looking beyond average returns. By considering the entire distribution of outcomes, we can better understand what investors should be aware of to help them stay invested when results aren’t what they expect.
As an example, the S&P 500 Index has returned about 10% annualised since 1926. But over that time period, there have only been six calendar years when the S&P’s return was within two percentage points of 10%.1 If investors were to adopt a strategy that tracks the S&P 500 Index expecting 10% each year, they need to understand that returns over any given period can look different.
So what does it take to stay the course? Our view is that while there is no silver bullet, there are some basic tenets that can help. Developing an understanding of how markets work and trusting markets is a good starting point. Having an asset allocation that aligns with your risk tolerance and investment goals is also valuable. We believe financial advisors can play a critical role in this determination. Finally, it’s important that the investment manager can be trusted to execute the desired strategy.
In this regard, an index-like approach is useful because of how transparent it is. It is easy for an investor to examine whether the returns achieved by the manager matched those of the index. This is part of the reason indexing has been a positive development for investors, offering a transparent, low-cost way to access markets. However, index funds prioritise matching an index over potentially achieving higher returns—so we believe they are too mechanical.
At Dimensional, we’ve sought to improve upon indexing, taking the best of what it offers and adding the ability to make judgments. Our experience has been that by incorporating a little bit of judgment, you can add a lot of value.
Dimensional began back in 1981 with a new idea: small cap investing. The premise was that many investors didn’t invest in small cap stocks, and that small caps behaved differently than large cap stocks and could offer diversification bene ts to investors concentrating in large caps. We found clients who agreed the idea was sensible. Over the next nine years, the performance of small cap stocks was disappointing relative to large caps
(at one point the S&P 500 outpaced our portfolio by about 10% annually), so on the surface it may have appeared that both we and our clients had a reason to be nervous. But clients were willing to stick with us because we were clear about our objective—providing a diversified portfolio of small cap stocks—and we delivered on it.2 Having compelling ideas is important, but the implementation of those ideas is what really counts.
1. In USD. Past performance is not a guarantee of future results. Indices are not available for direct investment; therefore, their performance does not re ect the expenses associated with the management of an actual portfolio. The S&P data is provided by Standard & Poor’s Index Services Group.
2. Diversification does not eliminate the risk of market loss. Investing risks include loss of principal and fluctuating value. Small cap securities are subject to greater volatility than those in other asset categories. There is no guarantee an investing strategy will be successful.
We place tremendous value on helping our clients understand why we do what we do. Just like those first years, we have lived through other times when the results have looked disappointing. This is one reason our approach combines our ability to make judgments with the transparency we believe is necessary for clients to understand what they can expect from us. The solutions we provide are meant to help clients achieve their financial goals. We know that a big part of enjoying the expected bene t of long-term returns relies on the ability to stay invested. By clearly articulating what we promise to provide, and delivering on those promises with robust portfolios, our hope is that we can help increase clients’ confidence in their decision to invest with us and provide them with a more successful investment experience.
On behalf of all of us at Dimensional, we want to thank our clients for the trust you have placed in us. We will continue working hard to reinforce the decision you have made. For those of you who may not yet work with us, we look forward to the prospect of serving you in the future.
Founder and Executive Chairman