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Most Stocks Suck!

Only 4% of the total number of stocks (1,092 stocks out of a total of 25,967) accounted for the net gain for the entire US stock market since 1926.

That’s the conclusion of a recent study by a professor of finance at ASU that Dan Solin referenced in his latest post. The data show that only a small fraction of stocks (1,092 out of 25,967) have accounted for the total net gain of the entire stock market since 1926. Most stocks (96%) collectively matched 1-month Treasury bill returns over their lifetimes. 1-month Treasury bills are risk-free! They are backed by the full faith and credit of the U.S. Treasury, which means that investors who bought all those stocks took on additional risk, for no reward.

This is just the latest evidence that supports the importance of broad diversification using low-cost index funds. It’s the only way to be sure your portfolio includes the small percentage of stock “winners” over the long term.

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Matrix Book 2019

The Matrix Book is a unique a tool for seeing decades of returns and telling stories about investing. In this video, Joel Hefner explains how a globally diversified approach can help investors stay on track toward achieving their long-term goals.

The annual survey of investment performance draws on historical data to look beyond short-term market fluctuations and shed light on the dimensions that explain differences in returns. The Matrix Book 2019 is embedded below for your reference.

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Perspective on Premiums

Investors may be tempted to extrapolate recent returns into the future, which can lead them to abandon their investment philosophy at potentially inopportune times. While negative outcomes are disappointing, investors should view them with the proper perspective and stay the course.

 

Brad Steiman
Head of Canadian Financial Advisor Services, Director, Vice President,
Dimensional Fund Advisors

Wei Dai
Vice President, Research
Dimensional Fund Advisors 

 

March 2019

When you leave your server a tip, do you round it to a whole-dollar amount and often in multiples of $5? Does a 60th birthday seem more significant than a 59th? If you answer yes to these questions, you’re not alone. Most of us prefer round numbers.

This preference leads many investors to review results by calendar year and to consider 10-year periods when evaluating long-term returns. People tend to place greater emphasis on the latest period due to recency bias and to extrapolate recent results into the future. For these reasons, we should put recent performance into the proper perspective.

During the most recent 10 years, equity investors have generally fared well, with the MSCI All Country World Index (IMI) earning an annualized return of 10.32% through 2018. Within equities, small cap stocks and higher profitability stocks have generally delivered outperformance relative to the market, but the underperformance of value stocks has garnered a lot of attention. Value investors may feel somewhat disappointed, as the MSCI All Country World Value Index (IMI) underperformed the market, delivering an annualized 9.23% over the same period.

We expect positive market, size, value, and profitability premiums,1 but also recognize that realized premiums are volatile and can sometimes be negative. Although a negative premium can be disappointing, it is not unprecedented—and we can look at historical data to gauge how often each premium has been negative. For example, Exhibit 1 shows the frequency of experiencing a negative premium in the US over rolling 1-, 5-, and 10-year periods as far back as the data are available.

As you can see, negative premiums occur from time to time. While the odds of realizing a positive premium are never guaranteed, they are decidedly in your favor and increase the longer you stay invested.

This analysis looks at each premium individually. What if you integrate all four premiums in pursuit of higher expected returns? A different approach is to calculate the frequency that one, two, three, or all four of the premiums were negative over rolling 10-year periods from July 1963 to December 2018. As shown in Exhibit 2, periods when one of the four premiums was negative— like the most recent decade—occurred in almost half of the rolling 10-year periods. However, the premiums do not move in lockstep, so there were relatively few instances of two negative premiums and virtually no instances of three or four negative premiums.

Percentage of rolling 1-, 5-, and 10-year periods with negative premiums is calculated using monthly return data from June 1927 to December 2018 for market, size, and value, and from July 1963 to December 2018 for profitability. Market: Fama/French Total US Market Research Index minus the One-Month US Treasury Bill. Size: Dimensional US Small Cap Index minus the S&P 500 Index. Value: Fama/French US Value Research Index minus the Fama/French US Growth Research Index. Profitability: Dimensional US High Profitability Index minus the Dimensional US Low Profitability Index. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. One-Month US Treasury Bills is the IA SBBI US 30 Day TBill TR USD provided by Ibbotson Associates via Morningstar Direct. Dimensional indices use CRSP and Compustat data. Past performance is no guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Fama/French indices provided by Ken French. Dimensional and Fama/French index definitions are available in the appendix. S&P data © 2019 S&P Dow Jones Indices LLC, a division of S&P Global.

In all likelihood, any premium that doesn’t materialize will get called into question. Plenty of ink will be spilled over scrutinizing the one that had the bad draw, even if that’s all it was. The US value premium has been under the microscope lately, but the other premiums have had their turn historically.

From an empirical perspective, a negative 10-year premium is not so far outside the range of outcomes to suggest that the premium no longer exists. More importantly, we have a sensible framework for expecting positive size, value, and profitability premiums. That framework is valuation theory, which posits that a stock’s price reflects the company’s expected future cash flows discounted to present value. The discount rate equals an investor’s expected return. Therefore, as long as stocks have different expected returns, those with lower prices and higher expected cash flows should have higher expected returns. This framework holds regardless of whether realized premiums have been positive or negative in the recent past.

Exhibit 3 confirms that premiums have, on average, been positive after periods of underperformance, although the data show a wide range of outcomes. In this analysis, we identify the rolling 10-year periods when a premium was negative and then observe how the premium behaved over the following 10 years. Profitability is excluded because there are only two data points.

Number and percentage of rolling 10-year periods with one, two, three, and four negative premiums are calculated using monthly return data from July 1963 to December 2018. Past performance is no guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. See Exhibit 1 for the definition of the premiums and data source.

Using monthly return data from June 1927 to December 2018, annualized premiums are calculated over the subsequent 10-year periods following a negative 10-year size, value, or profitability premium. The average, minimum, and maximum are calculated across all such 10-year periods for each premium. Excluded are 10-year periods that end after December 2018. Past performance is no guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. See Exhibit 1 for the definition of the premiums and data source.

Despite compelling theoretical and empirical evidence supporting the premiums, investors may be tempted to extrapolate the recent past into the distant future, which can lead them to abandon their investment philosophy at potentially inopportune times. Maintaining discipline and sticking to the plan are vital. The performance of premiums in the recent past doesn’t tell you much about future premiums. So, if your goals haven’t changed, then your asset allocation likely doesn’t need to change.

Furthermore, premiums can materialize quickly, and you want to be properly positioned to capture the returns when they show up. The period leading up to and shortly after the start of the 21st century provides an extreme, albeit anecdotal, example. Exhibit 4 shows the performance of the Russell 1000 Growth and Value indices. Growth beat value over every trailing period from 1 to 20 years ending March 31, 2000. Consequently, many investors found themselves questioning a value strategy, meaning they wondered if expected returns were still related to the price paid for a stock in the so-called “new economy.”

Past performance is no guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes.

Past performance is no guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes.

Investors who capitulated to this line of reasoning may have regretted their decision a mere 12 months later because the value index strongly outperformed the growth index, as illustrated in Exhibit 5, over every trailing period from 1 to 20 years, ending March 31, 2001.

The moral of the story? Negative outcomes are disappointing, but investors should view them with the proper perspective and stay the course!


APPENDIX

Fama/French Total US Market Research Index: The value-weighed US market index is constructed every month, using all issues listed on the NYSE, AMEX, or Nasdaq with available outstanding shares and valid prices for that month and the month before. Exclusions: American Depositary Receipts. Sources: CRSP for value-weighted US market return. Rebalancing: Monthly. Dividends: Reinvested in the paying company until the portfolio is rebalanced.

Fama/French US Value Research Index: Provided by Fama/French from CRSP securities data. Includes the lower 30% in price-to-book of NYSE securities (plus NYSE Amex equivalents since July 1962 and Nasdaq equivalents since 1973).

Fama/French US Growth Research Index: Provided by Fama/French from CRSP securities data. Includes the higher 30% in price-to-book of NYSE securities (plus NYSE Amex equivalents since July 1962 and Nasdaq equivalents since 1973).

Dimensional US Small Cap Index: Created by Dimensional in March 2007 and compiled by Dimensional. It represents a market capitalization-weighted index of securities of the smallest US companies whose market capitalization falls in the lowest 8% of the total market capitalization of the eligible market. The eligible market is composed of securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market. Exclusions: Non-US companies, REITs, UITs, and investment companies. From January 1975 to the present, the index also excludes companies with the lowest profitability and highest relative price within the small cap universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Source: CRSP and Compustat. The index monthly returns are computed as the simple average of the monthly returns of 12 sub-indices, each one reconstituted once a year at the end of a different month of the year. The calculation methodology for the Dimensional US Small Cap Index was amended on January 1, 2014, to include profitability as a factor in selecting securities for inclusion in the index.

Dimensional US High Profitability Index: Created by Dimensional in January 2014 and represents an index consisting of US companies. It is compiled by Dimensional. Dimensional sorts stocks into three profitability groups from high to low. Each group represents one-third of the market capitalization. Similarly, stocks are sorted into three relative price groups. The intersections of the three profitability groups and the three relative price groups yield nine subgroups formed on profitability and relative price. The index represents the average return of the three high-profitability subgroups. It is rebalanced twice per year. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Source: CRSP and Compustat.

Dimensional US Low Profitability Index: Created by Dimensional in January 2014 and represents an index consisting of US companies. It is compiled by Dimensional. Dimensional sorts stocks into three profitability groups from high to low. Each group represents one-third of the market capitalization. Similarly, stocks are sorted into three relative price groups. The intersections of the three profitability groups and the three relative price groups yield nine subgroups formed on profitability and relative price. The index represents the average return of the three low-profitability subgroups. It is rebalanced twice per year. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Source: CRSP and Compustat.

Profitability is defined as operating income before depreciation and amortization minus interest expense scaled by book. Relative Price refers to the share price (or market cap) of a firm’s stock, divided by a fundamental variable of the firm (e.g., earnings, cash earnings, dividends, net assets). One of the most widely used measures of relative price is the price-to-book ratio.

1. Market premium: The return difference between stocks and short-term bills. Size premium: The return difference between small capitalization stocks and large capitalization stocks. Value premium: The return difference between stocks with low relative prices (value) and stocks with high relative prices (growth). Profitability premium: The return difference between stocks of companies with high profitability over those with low profitability.

Past performance is not a guarantee of future results. There is no guarantee an investing strategy will be successful. All expressions of opinion are subject to change. This information is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services. It should not be considered investment advice.

Eugene Fama and Ken French are members of the Board of Directors of the general partner of, and provide consulting services to, Dimensional Fund Advisors LP.

UNITED STATES: Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.

CANADA: March 25, 2019.

These materials have been prepared by Dimensional Fund Advisors Canada ULC. Commissions, trailing commissions, management fees, and expenses all may be associated with mutual fund investments. Unless otherwise noted, any indicated total rates of return reflect the historical annual compounded total returns, including changes in share or unit value and reinvestment of all dividends or other distributions, and do not take into account sales, redemption, distribution, or optional charges or income taxes payable by any security holder that would have reduced returns. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently, and past performance may not be repeated.

MKT-2827 03/19 1621594

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Here’s the Prescription

As much as I value the unfettered access to information the internet provides, I recognize the potential harm that too much information can cause.

By David Jones
Head of Financial Advisor Services, EMEA and Vice President
Dimensional Fund Advisors Ltd.

December 2018

Take, for example, a friend of mine, who was experiencing some troubling medical symptoms. Typing her symptoms into a search engine led to an evening of research and mounting consternation. By the end of the night, the vast quantity of unfiltered information led her to conclude that something was seriously wrong.

One of the key characteristics that distinguishes an expert is their ability to filter information and make increasingly refined distinctions about the situation at hand. For example, you might describe your troubling symptoms to a doctor simply as a pain in the chest, but a trained physician will be able to ask questions and test several hypotheses before reaching the conclusion that rather than having the cardiac arrest you suspected, you have something completely different. While many of us may have the capacity to elevate our understanding to a high level within a chosen field, reaching this point takes time, dedication, and experience.

My friend, having convinced herself that something was seriously wrong, booked an appointment with a physician. The doctor asked several pertinent questions, performed some straightforward tests, and recommended the following treatment plan: reassurance and education.

Not surgery. Not drugs. But an understanding of why and how she had experienced her condition.

The consultative nature of a relationship with a trusted professional—both when a situation arises and as we progress through life—is one of the key benefits that an expert can provide.

There are striking parallels with the work of a professional financial advisor. The first responsibility of the doctor or advisor is to understand the person they’re serving so that they can fully assess their situation. Once the plan is underway, the role of the professional is to monitor the person’s situation, evaluate if the course of action remains appropriate, and help to maintain the discipline required for the plan to work as intended.

Like my friend’s doctor, advisors may have experienced conversations with clients that are triggered by news reports or informed by unqualified sources. In some cases, all that is required to help put the client’s mind at ease is a reminder to focus on what is in their control as well as providing reassurance and (re)education that they have a financial plan in place that is helping them move toward their objectives. The benefits of working with the right advisor are demonstrated through the ability to both help clients pursue their financial goals and to help them have a positive experience along the way.

Exhibit 1: Reacting Can Hurt Performance
Performance of the S&P 500 Index, 1990–2017

In US dollars. For illustrative purposes. The missed best day(s) examples assume that the hypothetical portfolio fully divested its holdings at the end of the day before the missed best day(s), held cash for the missed best day(s), and reinvested the entire portfolio in the S&P 500 at the end of the missed best day(s). Annualized returns for the missed best day(s) were calculated by substituting actual returns for the missed best day(s) with zero.

S&P data © 2018 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. “One-Month US T-Bills” is the IA SBBI US 30 Day TBill TR USD, provided by Ibbotson Associates via Morningstar Direct. Data is calculated off rounded daily index values. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results.

Trouble might arise when we confuse simple and complex conditions. Probably no harm is done when a person, recognizing the onset of a common cold, takes cold medicine, drinks plenty of fluids, and rests. But had my self-diagnosing friend not made an appointment with a specialist, and instead moved from self-diagnosis to self-medication, she may have caused herself real harm. Similarly, thinking that all aspects of your own financial situation can be handled through a basic internet search or casual conversation with a friend might result in a less than optimal financial outcome.

Without the guidance of an advisor, the self-medicating investor might overreact to short-term market volatility by selling some of their investments. In doing so, they risk missing out on some of the best days since there is no reliable way to predict when positive returns in equity markets will occur.1 One might think that missing a few days of strong returns would not make much difference over the long term. But, as illustrated in Exhibit 1, had an investor missed the 25 single best days in the world’s biggest equity market, the US, between 1990 and the end of 2017, their annualized return would have dropped from 9.81% to 4.53%. Such an outcome can have a major impact on an investor’s financial “treatment” plan.

Improving someone’s financial health is a lot like improving their physical health. The challenges associated with pursuing a better financial outcome include diagnosis of the current situation, development of the appropriate course of action, and sticking with the treatment plan. Many advisors are trained on the intricacies of complex financial situations and work to understand how their clients feel about money and how their clients might react to future events.

By providing the prescription of reassurance and education over time, we believe the right advisor can play a vital and irreplaceable role in investors’ lives.

1. The 2018 Mutual Fund Landscape report compiled by Dimensional showed that for the 15-year period through 2017, only 14% of US equity mutual funds and 13% of US fixed income mutual funds survived and outperformed their benchmark after costs. Refer to https://us.dimensional.com/perspectives/mutual-fund-landscape-2018 for more information.


Dimensional makes no representation as to the suitability of any advisor, and we do not endorse, recommend, or guarantee the services of any advisor, including those in the Find an Advisor portion of our website. Investors should carefully and thoroughly evaluate any advisor whom they consider hiring or working with.

There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal. There is always the risk that an investor may lose money. A long-term investment approach cannot guarantee a profit. Results for other time periods, including shorter time periods, may include losses.

All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.

Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.