aaii los angeles september 2014
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AAII presentation Los Angeles September 2014TRANSCRIPT
How to Beat the Market
Without Outguessing the Market
AAII
September 20, 2014
How do Most People Invest?
They Try to Predict the Future
“I have a proven system for
picking winning stocks.”
“The market is primed for a retreat.”
“That sector will continue
advancing through next year.”
They Act on Impulse
“I can’t take this bear market -
I’m getting out!”
“Everyone’s making money -
I want a piece of the action.”
They Bet on Tips and Hunches
“I heard it on cable news. I’d better sell!”
“I got a hot tip from my neighbor.
It’s a slam dunk.”
“My friend works in the industry -
he’s got the inside scoop.”
They Are Swayed by the Media
“How to Reach
$1 Million” Money, 08/2012
“The Death of Equities” Business Week, 08/13/1979
“The Crash of ’98
Can the US Economy Hold Up?” FORTUNE, 09/28/1998
“Retire Rich – A Simple
Plan to Have it All” FORTUNE, 08/16/1999
They Rely on Unreliable Track Records
“I don’t just pick average funds”
“I carefully examine the winning funds”
“I only invest in 5 star funds”
They are Plagued by Emotional and Psychological
Distractions
Claiming Losses Who to Trust
Sunk Cost Fear
Hindsight Bias Greed
Fooled by Randomness Overconfidence
Risk Manager 25,000 B.C.
Risk Manager 2012
What Have We Learned?
Why Flip a Coin?
Academic Research Provides Many Answers
Most of the Advancements in Finance
Have Come from Academia
Eugene Fama
Nobel Laureate, 2013
Kenneth French
Dartmouth College
Robert Merton
Nobel Laureate, 1997
Robert Novy-Marx
University of Rochester
William Sharpe
Nobel Laureate, 1990
Merton Miller
Nobel Laureate, 1990
Myron Scholes
Nobel Laureate, 1997
Peng Chen
Cornell University
Illustration based on voluntary participation at client event hosted by a financial advisor, August 2013. Results audited by advisor.
Together, We Know More Than We Do Alone
Participants were asked
to estimate the number
of jelly beans in a jar.
Range: 409-5,365
Average: 1,653
Actual: 1,670
In US dollars. US equity trades: Trade data from consolidated trade feeds and includes securities listed on the NYSE, AMEX, Nasdaq, and Regional exchanges. Source: Better Alternative Trading System (BATS)
Global Market Systems. US fixed income trades: Trade data provided by Federal Reserve Bank of New York, Municipal Securities Rulemaking Board, and FINRA TRACE. Source: Securities Industry and
Financial Markets Association (SIFMA).
Markets Reflect the Combined Knowledge
of All Participants
US Markets Trading in 2013 Equity Fixed Income
Average
Daily
Volume
$223
billion
$810
billion
Prices Incorporate All Available Information
Book Equity News about
Cash Flows
Risk
Considerations
Book Equity Expected Cash
Flows Discount Rate
Price
What is the Best Way to Invest?
Conventional Active Management
Indexing
Portfolio Engineering
Conventional Active Management
Attempts to identify mispricing in securities
Forecasting, security selection, market timing,
“Active Manager” track records
Higher expenses, higher trading costs, higher taxes,
excess risk
Relying on Active Manager Track
Records is:
UNRELIABLE
Source: Mutual Fund Landscape, Dimensional Fund Advisors 2014. Mutual fund data is from the CRSP Mutual Fund Database, provided by the Center for Research in Security Prices, University of Chicago.
Funds are identified using Lipper fund classification codes and are matched to their respective benchmarks at the beginning of the sample periods.
Conventional Investment Methods
Mutual funds that survived and beat their index for 10 years, ending December 31, 2013
19%
15%
Stocks
Bonds
19%
Predictive Power in Morningstar Ratings?
Indexing
Measurement tool not intended for investing
Allows commercial index to determine strategy
Attempts to track the benchmark
Accepts lower returns, reduced flexibility, higher
trading costs
Indexing Attempts to Track a Commercial Benchmark
Holds a basket of
securities represented
in the index.
Buys and sells the
same securities at the
same time as all other
funds tracking the
index.
INDEX
LIST
Market
Portfolio Engineering
Applies insights about markets and returns from
academic research
Structures portfolios along the dimensions of expected
returns
Adds value by integrating research, portfolio structure
and effective implementation
Viewing the Market in a Different Dimension
Market
Viewing the Market in a Different Dimension
Higher
Expected Return
Market
Lower
Expected Return
Portfolios Can Be Structured along
Dimensions of Expected Returns
Overweight Underweight
Market
Higher
Expected Return
Lower
Expected Return
Dimensions of Expected Returns
Sensible
Persistent across different time periods
Pervasive across markets
Cost-effective to capture
Statistically large and significant
Dimensions of Expected Returns
1. Relative price is the price of a security as it compares to another.
2. Operating income before depreciation and amortization minus interest expense scaled by book.
Do profits today contain information
about profits in the future?
Profitability Research
Identifying a Persistent Measure:
Include all major costs of doing business
Exclude nonrecurring items of profitability
Be comparable across sectors
Direct Profitability:
Operating income before depreciation
and amortization minus interest expense,
scaled by book value.
Dimensions of Expected Returns US Stocks
Size (Market Cap)
1928-2013 Small Large Premium
12.33% 9.78% 2.55%
Relative Price
1928-2013 Value Growth Premium
12.62% 8.94% 3.68%
Profitability
1964-2013 High Low Premium
12.98% 8.26% 4.72% Source: Dimensional Fund Advisors
Dimensions of Expected Returns Non US Developed Stocks
Size (Market Cap)
1970-2013 Small Large Premium
15.07% 10.06% 5.06%
Relative Price
1970-2013 Value Growth Premium
15.11% 9.16% 5.95%
Profitability
1992-2013 High Low Premium
9.03% 3.88% 5.15% Source: Dimensional Fund Advisors
Dimensions of Expected Returns Emerging Markets Stocks
Size (Market Cap)
1989-2013 Small Large Premium
12.78% 11.11% 1.68%
Relative Price
1989-2013 Value Growth Premium
15.08% 10.06% 5.02%
Profitability
1996-2013 High Low Premium
10.63% 4.23% 6.40% Source: Dimensional Fund Advisors
Practical Investing
Critical Components of Net Returns
ENGINEERING + + +
+ + EXECUTION
AND
+
EXPENSES
REVENUE
-
+
=
Beta
(Market) Size
Large - Small
Price
Growth - Value Profitability
More - Less
Index
Tracking Flexibility Style Drift Limits Momentum
Expense Ratio
Securities
Lending
Fund Return - Less tax impact
Taxable Accounts
From Insights to Implementation
Dimensional Fund Advisors Putting Financial Science to Work for You
Dimensional Fund Advisors Putting Financial Science to Work for You
Strategies based on academic research
Many firsts with the market
#1 choice among professional advisors
Worldwide leader adding value through trading
Available only through select advisory firms
Focus On What You Can Control
Let science work for you.
Let markets work for you; Capture returns.
Diversify intelligently.
Control expenses, taxes and turnover.
Stay disciplined.