aaii los angeles september 2014

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.