"The decision to rely on academic - not Wall Street - research was not an accident, even though it seemed strange at the time."
- David Booth -
investing With Academic Research
You would think of all places, the investment industry would be heavily influenced by research and academics.
Wall Street does do their own research, but is often focused on what sells versus what works.
But there is a shining star.
A lone investment company set out to revolutionize the industry by following the logic and strategies of leading academic minds.
The mission was simple: what if your hard earned savings were invested using financial science instead of using a financial salesmen?
This is their story.
Let me introduce you to Dimensional Fund Advisors.
I am a big believer that behind every successful person or company exists a great mentor.
You may be familiar with the story of who mentored Warren Buffett.
His life changed when he read a book by Benjamin Graham titled The Intelligent Investor. He was so enlightened he attended Columbia University to be able to take classes taught by Professor Graham.
Warren took Graham's teachings and ran with it. The rest is history.
Dimensional's story mirrors the same academic mentorship approach.
David Booth, a co-founder of Dimensional Fund Advisors, received a MBA from the University of Chicago in 1971. It was there he discovered the theories of finance, particularly under the tutelage of Professor Eugene Fama, often considered today as the "Father of Modern Finance."
A PARTNERSHIP FORMS
After a short stint working in the financial industry, David had a lightbulb moment.
Wall Street had not recognized the potential of the financial research going on. No one had yet to bridge the gap between academia and investors.
He stated, "When we started Dimensional, we knew these ideas were important, they just hadn't been widely recognized yet."
In 1981, he asked Professor Fama and other leading financial academic researchers to establish Dimensional's Board of Directors and just like that, Dimensional Fund Advisors was founded.
EVIDENCE BASED INVESTING
Their approach was logical in nature.
Instead of trying to outperform the stock market by picking stocks, Dimensional would try and outperform by capturing sections, or "dimensions" (hence their name) of the broad stock market that have demonstrated historical outperformance compared to a benchmark.
In other words, an investment strategy based on historical data of the broad stock market, not the skill or management style of any one human being.
I like to say replacing the crystal ball with text books.
This was a game changer. And also an ego buster to Wall Street.
Wall Street is all about the concept of the smartest man in the room. There is no way investing in a broad basket of stocks could possibly do better than a highly educated and expensive suit wearing money manager.
The proof is better left for another post, but I'll put it this way. Outside of Warren Buffett, can you name another professional investor?
Yet that's how good Wall Street is at selling. Large corporations and insurance companies are still viewed as your main outlet to manage your money.
They've gotten there by using every trick in the bag.
Using financial science to find a better way to invest seems logical. Applying it is much more difficult.
Patterns and trends exist everywhere. For example, you could look at markets that tend to perform well depending on who is President. Or based on the level of interest rates. Or the seasonality of the weather.
The key is finding those variables that have enough prevalence and robustness to act upon.
Dimensional explains how they deciphers their research below:
THE CORE PRINCIPLES
It started small. As in small companies.
Fama and his colleague Kenneth French, wrote a ground breaking research paper in 1992 titled The Cross Section of Expected Stock Returns (link).
The theory was simple. Small company stocks, traditionally identified as having a market capitalization under $1B, have historically generated higher returns compared to large company stocks, traditionally defined as having a market capitalization greater than $10B.
In other words, investing in companies that start small and have room to grow tend to produce higher returns over the long run (barring they survive!) than already established companies.
Check out the evidence below:
From the historical graph above, you can see the yellow line representing the US Small Cap Index has significantly outpaced the US Large Cap Index.
"DIMENSIONS" TAKE SHAPE
Their curiosity was just getting started. Were there other dimensions of the stock market that displayed a tendency to outperform?
All together, Dimensional has identified four main equity dimensions and two main fixed income dimensions that have enough robust research to build investments around.
HOW IT WORKS
Dimensional Fund Advisors are often compared to an index fund. If you are investing in a broad basket of stocks, you are in essence an index.
To an extent, Dimensional Funds are index funds. With a twist.
The advantage for Dimensional is they don't restrict themselves to a completely hands off approach like most index funds. They are not in the business of picking stocks, but they do have the ability to overweight, or tilt, to portions of the broad stock market.
This ability to maneuver allows them to capture the dimensions they want.
By starting with the diversification benefits of an index, and adding in the financial science of capturing strategic dimensions of that index, you have the ability to capture higher returns.
BOTTOM LINE: DOES FINANCIAL SCIENCE LEAD TO BETTER RESULTS?
Dimensional Funds has all the performance information you could want on their website.
What really matters to me is:
1. Are they doing better than managers picking stocks?
2. Are they doing better than an index?
Check out their results below:
HOW TO INVEST
Dimensional Funds are not available to the general public. To purchase their funds, you must go through an approved Financial Advisor.
This is not a sales tactic, and Derive Wealth is not affiliated with Dimensional in any way. But it does help ensure those who do invest believe in their philosophy and invest for the long term.
We feel it's our mission to bring cost effective, science-based investing to those who believe in it.
First, we conduct a personal webinar educational class with you to make sure you understand how investing works. It's also a time for you to ask questions.
Second, we ask you take our 5-year pledge. Five years is the minimum amount of time we have researched to allow Dimensional's strategies to play out.
This is a pledge, not a contract. You can access your investments anytime, but our hope is you understand how short term investing usually doesn't lead to positive returns.
WHAT IT COSTS
By going through our approval process, we reward you with a simple and cost effective fee structure:
$10 per month per account. That's it.
The only other costs you bear is transaction costs, which currently runs at $9.99 per trade (this fee is charged by our custodian, TD Ameritrade Institutional).
Believing in financial science and academic research goes beyond just investing. It applies to every aspect of pursuing higher returns.
And the fees you pay to an advisor plays a critical role.
Derive Wealth is an independent, 100% fee-only financial planning firm located in Pasadena, CA. We specialize in creating personal financial plans designed to organize your life, get you to your goals, and take the worry out of your money. We don't sell products and don't work on commissions. Instead, we provide financial advice you can believe in.