There’s been a big response to Part 1 of my interview with Dr Gerard O’Reilly, the new Co-CEO of Dimensional Fund Advisors. In it he explained how everything Dimensional does is underpinned by empirical research, and how tilting towards size, value and profitability premiums should, over time, deliver market-beating returns.
The problem, of course, is that you can know your Fama-French inside out, but if investors don’t know themselves, and particularly their ability to deal with their emotions in falling markets, they risk having a bad investment experience.
In Part 2 of the interview, Dr O’Reilly explains the need for patience and discipline, and also the importance of global diversification. He gives his opinion, too, on how investors should view recent stock market highs. Finally, he explains why Dimensional, as a company, puts so much emphasis on the value of financial advice.
RP: Fama and French have identified a number of risk factors that tend to deliver higher returns over time. The ones Dimensional focuses on are size, value and profitability. To what extent should investors diversify across those different factors?
GO’R: I would say a good approach is a globally diversified portfolio to begin with. Global diversification is your friend in equities and it’s your friend in bonds. Now, that doesn’t mean that global diversification won’t result in some periods where you have disappointing returns, or negative returns; that’s not what global diversification does for you. But it does improve the reliability of your ability to pursue factor premiums. So, start with a globally diversified portfolio, then overweight smaller cap stocks, lower relative price, or value, stocks, and higher profitability stocks, in a measured way. You should have all three in one portfolio.
There will be years when small caps underperform large, or value underperforms growth, or high profitability underperforms low profitability. There will be some of those years. But by having a well-diversified portfolio that pursues all of those premiums, you smooth out those years a little bit. While there will still be the possibility of underperformance, you improve the possibility of outperformance.
The other thing I would mention is the time horizon. While such a portfolio has positive expected outperformance every day, what’s expected doesn’t always happen. But the probability of what’s expected happening increases the longer the holding period. That’s what you see if you extend the holding period to ten years or 20 years — the possibility of negative size, value or profitability premiums decreases dramatically. So for folks with long horizons, the probability of them realising those premiums goes up.
RP: But is there a danger that, as more and more tilt towards these factors, the premiums associated with them will eventually disappear?
GO’R: To address that question you have to ask, is there a danger that people demand the same expected return to hold every stock in the world? If the answer to that question is Yes, and there’s no difference in expected returns across stocks, there’ll be no premiums of any kind. I think the probability of that happening is small. People demand differences in expected returns to hold different securities for lots of different reasons. Differences in perceived risk may be one of those reasons. But I think it’s a highly unlikely state of the world where, with every stock, no matter what the stock, investors are willing to hold each and every one of those at exactly the same rate of return.
As soon as you have differences in expected returns, that’s a discount rate effect, and you’ve got value and profitability premiums. What’s value telling you? People are willing to pay a lower price for this stock and a higher price for that stock. Low price, high discount rate. Profitability? This stock has higher expected cash flows than that stock. High profitability versus low profitability. If the price is the same, there’s a higher discount rate. As soon as you acknowledge that there can be differences in expected returns across stocks, it implies you have premiums.
Now, the question becomes, what’s the expected magnitude of those premiums? Could they decrease over time? That’s a possibility, though it’s something that’s difficult to measure one way or the other. They can get bigger or smaller for lots of different reasons. The way that we at Dimensional think about it is that if you take a measured approach, so that you still remain globally diversified, with thousands of stocks in your portfolio, even if the premiums are smaller or bigger (and you don’t know what they’re going to be in the future), you’ll end up with a good investment solution.
One last point I would make is this. Imagine everyone wants to become a value investor. What happens to value stocks? They become growth stocks. What happens to growth stocks? They become value. The market has to be held by everybody, and if everybody loves value, you should expect a strong premium from value, while all the value stocks move to growth and all the growth stocks move to value. So, even from a conceptual perspective, you’ve got to think about it at the stock level and how those premiums are realised over time.
RP: Stock markets have had been on a good run for many years now. How, if at all, should that affect the way that investors approach the markets at the moment?
GO’R: The first thing you need to recognise when you’re going to invest in the stock market is there will be periods of positive returns in the future, and there will be periods of negative returns. When those will occur, that’s unpredictable. You can’t say when the returns will be positive or when they will be negative. But you have to acknowledge that if you’re going to invest in stocks, there’s going to be volatility associated with the value of your investment. Accept that from the beginning, because it is going to happen. We will have negative returns in the future; we will have positive returns in the future.
Now the question you have to ask yourself is, at any point in time, do you think that investors, in aggregate, set prices to a level such that the expected return is negative? No. Investors don’t sign up for a negative expected return when they’re putting the value of their assets at risk. When they invest in stocks there’s uncertainty about what their future wealth will be. They demand compensation to bear that uncertainty. So prices are set to such a level that the expected equity premium is positive.
If what’s expected comes to pass, you get positive returns. But will something worse than is currently expected today come to pass? Well, I don’t know! What’s expected today, and all the information that’s aggregated across market participants around the world, is in the price today. So if something unexpected happens in the future, yes, we could have negative returns if it’s unexpectedly bad; if it’s unexpectedly good, we could have even more positive returns.
What you have to acknowledge is that, when you invest in stocks, there’s going to be volatility. There’s going to be tough times and good times. Set an asset allocation that you can live with, that has a good balance between stocks and bonds, so that you can ride out those tough times and stay disciplined, and then stop worrying. Markets are good at pricing information. They’re good at setting themselves up to have positive expected returns. But things that are unexpected always happen. And that causes markets to go up and go down.
RP: Dimensional positively encourages investors to use a financial adviser. Why is that?
GO’R: There’s a rich field of academic finance that has been developed over 50 or 60-plus years. It’s complex, it’s deep and it takes a lot of expertise to understand. It’s just like medicine. Why do you have a medical doctor? Because they have expertise. They’ve dedicated their lives to understanding something that most people haven’t dedicated their lives to understanding, and they can provide you valuable services that can give you a better experience, because they’re keeping abreast of all that medical research and all those advances in medicine. It’s the same thing when it comes to financial advice. With any field, there are going to be experts who can help people have a better experience, and that’s true when it comes to investing.
Something that is very important when it comes to investing is discipline, and financial advisers can help to instil that discipline in investors, so that they stay the course. As I said, returns are going to be strong and they’re going to be disappointing. You’ve got to get used to that right up front when you invest in markets. It’s important, if you can have a long time horizon, that you increase the probability of realising positive returns in all the various asset classes that you can invest in. A financial adviser can help explain what all those different asset classes are, how they come together, and then, when returns are disappointing, help keep the investor focused and disciplined.
There are other aspects to having a financial adviser too. I have a financial adviser who can help me with tax planning, estate planning and all the different types of wealth planning that most people don’t spend a lot of time gaining the expertise to be really good at. Some do, but not everybody does. So you can really have a better overall experience across all aspects of your financial health through working with an adviser.
If you missed the first part of this interview, here it is:
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