THE SCIENCE OF SUCCESS

LONG-TERM EVIDENCE PROVES THAT DISCIPLINE AND DIVERSIFICATION ARE MORE EFFECTIVE THAN TRYING TO BEAT THE MARKET.
By Dan Wheeler, Director of Global Financial Advisor Services for Dimensional Fund Advisors.  Article published in Financial Planning, February, 2007.

One of my biggest professional roles is to help advisors do their best on behalf of their clients.  The way I see it, you have a fiduciary obligation to help ensure that your clients not only meet their financial goals, but that they also achieve those goals with as little stress along the way as possible.  That, essentially, is how I define a successful investment experience.

Delivering that experience comes from following a model of investing that is fundamentally different from the approach that most investors take.  The approach that I stand behind is rooted in science and the empirical findings of some of the investment community’s brightest minds, people like Eugene Fama, a contender for the Nobel Prize in economics, and Brad Barber, a pioneer in the field of behavioral finance.  Their research forms the framework of an investment philosophy that emphasizes true investing over speculation.

Of course, you are advisors, not academics.  All that science isn’t of much use unless it translates to lessons that you can use to deliver real investment value to your clients.  Fortunately, this high-level investment philosophy translates to lessons that are straightforward, practical and useful in building and maintaining optimal portfolios for your clients.

A NEW MODEL OF INVESTING

In a previous column, I argued that the stock market is efficient overall and that even on those occasions when prices don’t reflect all known information, it’s smart for investors to act as if they do.  That’s because the chances of any single investor being able to exploit those occasional mispricings on a consistent enough basis to make a meaningful difference in total return are exceptionally slim.  Capital Markets Work.

The science of investing is therefore based around the idea that you should look to capture the performance of the capital markets, do what works, instead of trying to enhance returns through stock picking, market timing and track record investing.  These three strategies are essentially nothing more than speculation and gambling by trying to predict the unknowable future of a company, market or country.  Of course, numerous studies on the failure of active managers prove this to be true.

As an advisor, you have a responsibility to keep your clients from acting as speculators and to keep yourself from acting as such when making decisions on their behalf.  By rejecting a speculative approach, you can start treating investing as a process of identifying the risks that compensate investors, the sources of investment returns as determined by financial science, and then deciding how much of those risks each client should take.  Clearly this removes much of the day-to-day stress associated with picking stocks and markets.  And if you do want to enhance returns, you can do so through strategic portfolio design.

STRUCTURING RISK

So what does financial science tell us about which risks are worth taking?  Research over the past five decades reveals three main truths.  For starters, stocks are riskier than bonds and therefore have larger expected returns, a conclusion we all accept and take for granted by now.  But what about relative risk among stocks?  Here, we’ve learned that small company stocks have larger expected returns than do large company stocks.  And we have discovered that value-oriented shares have higher return expectations than do shares of growth oriented firms.  The reason is because investors, acting rationally based on known information, discount the prices of small company stock and value company stocks because of the additional risk in these investments.  To compensate for that risk, these stocks’ prices are set lower by the marketplace, allowing for greater upside potential.

In the fixed-income realm, we’ve learned that fixed-income securities are better used as methods to manage risk than they are to boost returns.  Therefore, portfolios consisting of bonds with relatively low risk-such as shorter-term, high-quality debt, let investors manage volatility or take on more exposure to the equity risk factors that are responsible for generating returns. 

Numerous details about these risk factors can be explored in other columns.  For now, the important thing to understand is that financial science has taught us to view investing in the context of risk.

This viewpoint allows advisors to build and maintain portfolios around those risk factors that compensate investors.  Your job doesn’t need to, nor should it, focus on picking the right stocks and avoiding the wrong ones.  Instead, your strategy can center around deciding how much you want to hold in stocks versus bonds, how much to hold in small company stocks relative to large company stocks, and how much to hold in value stocks versus growth company stocks.  This strategy is both simpler to execute and more advantageous to your clients’ financial lives because it is based entirely on how markets actually work to create wealth.

An additional element of structuring portfolios around risk is to reduce exposure to risks that don’t capture additional returns.  To do this, avoid concentrated portfolios that hold too few securities and refuse to speculate be betting on specific countries or industries, none of which is a proven factor in terms of risk and return.

FINANCIAL SCIENCE

The lessons of all this science boil down to two main concepts that you can use to guide every investment decision your clients make:

DIVERSIFICATION.  Economist and Nobel laureate Merton Miller says it best:  “Diversification is your buddy.”  Indeed, the way to avoid the risks associated with owning too few stocks and owing the wrong stocks is simple:  OWN THEM ALL.

DISCIPLINE.  The types of portfolios that financial science tells us to create are proven to work.  But the point to remind clients about is that they work over time, not every single year.  That’s why the key to achieving investment success is to stick with the investment plan through thick and thin.

Keeping clients disciplined can be extraordinarily difficult, largely because the media and much of the financial services industry send the message that success comes by taking action.  Furthermore, behavioral science tells us that our own emotions and biases can cause us to break our discipline at the wrong time.

The key is to keep your clients committed to a successful investment plan during those rough periods, and to keep yourself on track as well.  Remember, you are also susceptible to the urge to take unnecessary action.

If you’re thinking that these two lessons of financial science aren’t particularly sexy, you’re absolutely correct.  The sizzle of smart investing is that, there is no sizzle.  Helping your clients achieve success with the minimal amount of stress doesn’t have to be an overly complex proposition.   Investing doesn’t have to be sexy, is just has to work.  Years of research tells us that this approach works if you’re willing to stay committed to it.  In the end, that’s what will count to your clients.

We’ve included this article originally featured in the February, 2007 edition of Financial Planning because this is precisely the investment philosophy we utilize in designing our client’s investment portfolios.  Contact our office to obtain more information on how you can implement this tried and proven scientific approach in your investment portfolio.